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Luke Kawa

Fred Lum/The Globe and Mail

Bank of Canada Governor Stephen Poloz's hint that the central bank would wait to see how the economy fared before cutting rates again continues to inspire a radical re-evaluation of foreign exchange and interest rate assumptions.

Positioning on the Canadian dollar remains negative, but analysts are now wondering whether the early year collapse in the loonie was a case of the currency moving too far, too fast.

The Canadian dollar fell by 9 per cent against the U.S. greenback in the first month of 2015. As Bank of Montreal chief economist Douglas Porter pointed out at the time, there has been only one year – 2008 – in which the loonie decreased in value by more than that amount.

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The drivers of the loonie's epic drop-off were the decline in the price of oil, which plays a large role in the nation's terms of trade, the ensuing deterioration in the growth outlook, and monetary policy action – with the presumption that more was on the way – to mitigate these negative effects.

That final piece to the puzzle, it seems, won't be holding down the loonie – at least for now. At this moment, the market is not completely convinced that the Bank of Canada will cut rates again this year.

Dana M. Peterson, economist at Citi Research, believes the Bank of Canada will hold off on additional rate cuts, and sees monetary policymakers' next move as a hike in the third quarter of 2016.

"We believe that the BoC is likely to pause given (1) uncertainty over the timing of global oil market rebalancing and stabilization; and (2) as Canadian lenders continue to resist compliance with the January monetary policy easing," she wrote.

Ms. Peterson's second point warrants some scrutiny. Rate reductions would still presumably offer partial stimulus through the rates channel by stimulating consumer borrowing and/or reducing interest payments, and also additional stimulus via the foreign exchange channel. Even if the the big banks' decision to only pass along some of the last rate cut has somewhat blunted the efficacy of monetary policy, that's not sufficient reason for inaction.

Daniel Brehon, foreign exchange strategist at Deutsche Bank, points out that the implied odds of another Bank of Canada rate cut this year have declined to nearly where they were at the end of January, shortly after Poloz & Co.'s surprising move. On Friday, markets had priced in almost two cuts from the central bank this year; now, not even one is fully priced in.

Mr. Brehon believes that Mr. Poloz's comments could be the first sign that central bankers around the world aren't planning to ease as much as traders anticipate.

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"Investors seem eager to ask 'who is next?' in the global race to the bottom in yields while taking advantage of U.S. economic outperformance and rate spreads through long dollar positions," he wrote. "But surely at some point currency depreciation will have an impact on the real economy, opening trade deficits between the U.S. and other nations while transferring some of the U.S. growth and inflation outperformance to its trade partners."

With that in mind, it's interesting to compare the connection between the foreign exchange and rate markets of Canada and Australia, another nation in which commodity prices have a large impact on economic activity.

The Jan. 21 rate cut also sparked a selloff in the Aussie dollar relative to the U.S. dollar, and set the stage for the Reserve Bank of Australia's rate cut at the start of February.

On Wednesday, the odds of the Bank of Canada lowering the overnight rate to 0.5 per cent and the Reserve Bank of Australia cutting its cash rate to 2 per cent next week were equal, at 36 per cent. Overnight, however, they began to chart more independent courses.

Australian private capital expenditure fell 2.2 per cent on a quarterly basis in the final three months of the year, a larger decline than was anticipated. More importantly, the initial estimate for capital spending in 2015-2016 came in well shy of the consensus estimate. The implied odds of a rate cut from the Reserve Bank of Australia next week jumped to 45 per cent in the wake of this print.

Meanwhile, the firmer-than-anticipated Canadian CPI numbers prompted traders to further trim their expectation of a similar move from Canadian monetary policymakers down to 26 per cent. As one would expect, the Canadian dollar is gaining on its Australian counterpart.

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Early in 2015, the monetary policy narrative was black-and-white: the U.S. was on the verge of embarking upon a tightening phase, while the rest of the world would be in easing mode.

Now, the story has become much more convoluted: the Federal Reserve seems to be in no hurry to raise rates, some central bankers – like Mr. Poloz – are signalling pauses, and others are expected to continue to make monetary policy more accommodative.

Since one source of downside pressure on the loonie has been removed, investors should be aware that the U.S. dollar - which was on a tear on Thursday - is likely to drive the pair's movements in the short-term.

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