Should you buy or sell the Canadian dollar as inflation fears ease?

Financial market tensions led investors to be less interested in economic data and focus on the banking crisis. While the US and European banking sector events created increased market volatility, inflation news from Canada should help ease some concerns.

Headline inflation in Canada rose less than expected. The monthly reading of 0.4% is good news because the annual rate of consumer price inflation dropped to 5.2% from 5.9%.

It means that the Bank of Canada may have already reached a peak in interest rates. If that is so, one may also build a case for the future path of the federal funds rate.

The Federal Reserve meeting is the main event of the trading week. Thus, the Canadian dollar may not be in focus, but the inflation data does help in understanding changes in inflation trends globally.

What impact has the inflation report on the Canadian dollar?

Rising inflation led to major central banks acting by hiking the interest rates. The tightening cycle turned out to be one of the fastest in history, disrupting financial markets because yields rose and bonds tanked.

Under normal circumstances, a currency directly correlates with the inflation rate. Therefore, higher-than-expected inflation should be bullish for the currency because the market participants increase their bets that the central bank will hike the rates further.

Only there is one catch. That is, the lag the rates need to “make their way” into the economy.

Effectively, it is estimated that several months are needed before these effects are seen. Yet, the currency market moves instantly.

Therefore, interpreting the inflation report should be taken with a grain of salt. On the one hand, softening inflation should be bearish for the Canadian dollar as it suggests that no more rate hikes are coming.

On the other hand, when trading, one buys or sells a currency pair. The exchange rate reflects the value of one currency in terms of another, so by selling the Canadian dollar, one needs to buy another currency.

But if inflation trends change globally, then investors will start pricing the end of the tightening cycle. Hence, trading the Canadian dollar solely on the inflation report is risky because of what the report means for the overall market.