The U.S.’s return to caution compounded the loonie’s woes
The U.S. Federal Reserve’s (the Fed) latest decision to cut rates by 25 basis points (one-quarter of a percentage point) wasn’t a shock to anyone paying attention, but the message that came with it certainly was a surprise for the market. Fed chair Jerome Powell emphasized that the process had entered a “new phase”, marked by caution and a close watch on inflation’s progress. The headline takeaway was clear: the pace of cuts will slow next year. But the dot plot? That was the real curveball. Instead of the three cuts for 2025 that most were expecting, the Fed’s median projection showed only two, which brought long-term rate expectations to their highest level in six years.
This cautious pivot has some logic to it. Inflation, while cooling, remains sticky, and Powell is fully aware of the clock ticking on his tenure. With 17 months left as Chair, he has no desire to go down as the next Arthur Burns (the Fed chair known for letting inflation run rampant). That means he’s willing to keep monetary policy tight if it gives inflation no room to rebound. He stressed multiple times that the labour market, while less tight than in 2019, is not a roadblock to bringing inflation back to target. The messaging here is clear: Powell isn’t taking any chances.
Markets, however, didn’t appreciate this "cautious" shift. The rule of 20 — a simple valuation tool measuring the S&P 500’s earnings yield relative to inflation — can explain much of the markets’ reaction. As rate expectations rise, equity valuations take a hit, and this week was no exception. Small caps bore the brunt of it, falling 5% at their lowest point, while the Nasdaq had its worst day since July’s big carry trade collapse. And the Dow made history with a 10-day losing streak, its longest since 1974. This wasn’t just a tech problem, however; valuation-driven selling was the name of the game across the board.
The bond market wasn’t spared either. The three-month/10-year yield curve, which has been inverted since 2022, finally dis-inverted, as long-term yields climbed. The U.S. dollar took full advantage of the chaos.
The Canadian dollar was caught in the crossfire. The political chaos caused by Finance Minister Chrystia Freeland’s departure was already making an impact. But following the Fed’s speech, the heightened divergence between the Bank of Canada’s (BoC) path and the Fed’s cautious shift put downward pressure on the loonie. The BoC has been cutting rates at a more aggressive clip, signalling a willingness to ease further in 2025. This growing gap in policy stances led to a drop in the Canadian dollar, pushing it to its weakest level since early 2020. The loonie is essentially caught in a policy tug-of-war, with rate differentials and U.S. dollar strength working against it.
As we approach 2025, we wish you joyful holidays filled with warmth and happiness and look forward to reconnecting with you on January 10.
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