MARKET TONE
The USD dollar (USD) is starting the year with broad weakness, reflecting a mix of weaker data and deteriorated sentiment. The labour market is showing signs of renewed softness, weighing on consumer confidence and hinting to intensifying headwinds for the US economy. Fed policymakers are calibrating their response within the context of a complex relationship to the US administration, given judicial proceedings against Chair Powell and the nomination of the traditionally orthodox Kevin Warsh.
We have made no changes to our FX forecast, and we continue to expect broad-based weakness in the USD against all of the major developed economy currencies. The weak USD forecast extends through 2026 and into the end of our forecast horizon at the end of 2027, reflecting an outlook for relative central bank policy that includes near-term Fed easing, steady policy settings for the Fed’s peers, and longer-term tightening from some of the smaller growth-sensitive central banks whose economies are more closely tied to global commodity prices.
Growth trends in the US are mixed, with ongoing challenges in housing and manufacturing balanced against resilient services. The media’s breathless coverage of high profile investment in the technology sector, to support the build out of artificial intelligence, remains an important source of confidence. Financial conditions remain conducive to the effective transmission of monetary policy, however there appears to be an elevated sensitivity to any sign of deterioration. The presidential cycle is an added consideration for investors, given that mid-term years are historically challenging for equity markets.
Scotiabank’s Fed forecast continues to anticipate 75bps of easing in 2026, with 50bps in Q1 and a final 25bp cut in Q2, delivering a terminal policy rate of 3.00% for this easing cycle. The rate is expected to remain unchanged at 3.00% through the end of our forecast horizon (Q4 2027). Softened data and prospective leadership changes at the Fed are tilting the balance of risk toward greater easing, not less. Chair Powell’s presumed replacement, nominee Kevin Warsh, is a former Fed governor with extensive private financial sector experience across major banks and hedge funds. His policy views lean toward a more orthodox execution of the Fed’s remit, preferring conventional (interest rate) policy over unconventional (balance sheet, communication) tools that have been deployed over the past 15–20 years. A Warsh-led Fed would likely lean toward lower rates as a counterweight to balance sheet normalization and favour less communication.
Structural trends also favour medium-term USD weakness, given wide fiscal and current account deficits that are expected to broaden even further. The risks for the USD are a major—and intensifying—concern for global investors, whose increasing demand for hedging protection will only serve to add to the bearish pressure on the USD.
The theme of trade policy uncertainty has extended into 2026, generating the first round of broad-based USD weakness in mid/late-January as market participants responded to President Trump’s tariff threats in response to his pursuit of Greenland. A weaker USD remains the most effective lever to support the president’s trade objectives.
Upside risks to our USD forecast centre on the outlook for inflation, and the possibility of a renewed upswing, in a manner similar to that observed in the late 1970s, when a resurgence followed the initial decline from the mid-1970s peaks. Oil prices remain critical to this risk, and we remain tightly focused on geopolitical developments.
The Canadian dollar (CAD) has had a choppy start to the year, initially weakening in response to weaker oil prices and wider US-Canada spreads but ultimately recovering to end January with a push to fresh 16-month highs. The CAD’s latest gains have been fundamentally driven, reflecting softened Fed expectations that have narrowed interest rate differentials in the CAD’s favour. The Bank of Canada (BoC), on the other hand is decidedly neutral and highlighting the limited impact of monetary policy in managing structural challenges. A meaningful recovery in oil prices also appears to be underway, adding to the CAD’s fundamental gains.
The accommodation provided by the BoC’s 2025 rate cuts have delivered an important source of support for the Canadian economy, complementing the stimulus provided by the latest Federal budget. The BoC is expected to deliver 50bps of tightening in 2026, with one 25bp hike in each of the final quarters of the year. Another 25bp hike in Q1 2027 will lift the BoC’s policy rate to 3.00%, fully eliminating the policy rate gap to the Fed. We have made no changes to our USDCAD forecast, targeting 1.33 for the end of 2026 and 1.30 by the end of 2027. Trade policy risks remain a major source of uncertainty to our forecast, given the renegotiation of the USMCA that is scheduled for July 1st, 2026.
The euro (EUR) traded defensively to start the year but quickly bounced back in response to sentiment-related weakness in the USD. The EUR’s subsequent gains delivered a break to fresh highs reaching levels last seen in 2023. The European Central Bank (ECB) has maintained a decidedly neutral tone for several months, cautiously fading a dovish bias that had been introduced on the basis of trade policy uncertainty. Sterling (GBP) faces some near-term uncertainty related to politics and PM Starmer’s ability to remain in government. The currency remains fundamentally ‘cheap’ however, and mixed data have forced markets to soften their expectations for easing from the Bank of England (BoE). For JPY, the outcome of the latest election has delivered a resounding mandate for PM Takaichi along with a relief rally in the yen (JPY). Market participants had been concerned about the PM’s fiscal platform and hopes for central bank cooperation, and have responded positively to Takaichi’s message of continuity and coalition building as she purses her goals. The risk of another Bank of Japan (BoJ) pause appears to be moderating, as market participants consider policymakers’ undaunted and public expressions of their preference for continued tightening, calling for rate hikes at some point in 2026. Lower US yields and tighter US-Japan spreads should deliver fundamental support to the yen in 2026.
For Latam FX, a multitude of developments offer mixed drivers for different currencies. Slowing economic growth in the US is a negative for Mexico and the peso (MXN), however this is balanced by a broad rise in commodity prices that should deliver better terms of trade for Chile and its peso (CLP). Elections in Brazil and Chile are scheduled for October and November, respectively, and will provide considerable headline risk in the back half of 2026.
Eric Theoret, Canada 416.863.5934
FX FORECASTS
CAD FX FORECASTS
FEDERAL RESERVE AND BANK OF CANADA MONETARY POLICY OUTLOOK
FEDERAL RESERVE—FURTHER EASING AHEAD
We forecast with modest confidence three rate cuts this year down to a 3% fed funds overnight rate followed by a prolonged hold. We haven’t given up on March since there is still a lot of data on jobs and inflation to sift through before then, but the odds have grown slimmer.
Inflation risk remains material, but we think the Committee will respond more to the evidence of a deteriorating job market while moving toward a more neutral stance. One reason for this is that it’s often how they’ve behaved in the past.
A second reason is that if the job market is deteriorating, then it could be a leading sign of broader problems in the economy that would diminish capacity pressures and hence reduce inflation risk. For example, the pace of nonfarm payroll gains began ebbing and turned negative well before markets and GDP fell in late 2008.
Third is that the job market is deteriorating even after a rather illusory recent gain (here) and the drop in the unemployment rate is doubtful (here). Chart 1 shows that nonfarm payrolls excluding health care and social assistance have been weak for an extended period. Of nonfarm’s 130k gain in January, 124k came through health care and social assistance (42k) that are vulnerable to expired ACA subsidies.
On the hawkish side is upside inflation risk and that has several on the FOMC worried. The US economy is still in excess demand, and supply chain cost pressures are likely to rise. Tariffs are only a subset of such pressures. It’s too soon to say productivity growth may temper some of the inflation risk and the US could be in an AI-investment bubble.
Chair Powell hands over to Chair-nominee Warsh after April. Warsh will then need data to back any dovish bias to convince a majority of the 12 FOMC members that cutting is the correct way to proceed.
BANK OF CANADA—NEXT MOVE UP?
The BoC is forecast to be on a long pause at an overnight rate of 2.25% until we have 75bps of hikes over late 2026Q4 into 2027. Elevated uncertainty means there are non-zero probabilities to many rate scenarios.
Don’t expect much from the BoC anytime soon. The BoC’s recent communications are ambivalent toward the direction or timing of the next policy rate move because they lack confidence in assigning probabilities to different scenarios.
They describe the policy rate as remaining appropriate while evaluating developments (recap here).
Governor Macklem’s recent speech reminded markets that the BoC won’t just be looking at demand-side activity readings like GDP but is concerned about the supply side and hence determining whether developments are cyclical or structural in nature. The answer is important to assessing inflation risk and will take a lot of time and data to evaluate.
Our foundations for a future tightening bias include a starting point of a zero real policy rate at the lower bound of neutral rate estimates that offers insurance against downside risks. It’s too soon to evaluate the full effects of past monetary easing.
We expect the economy to gradually gain traction through fiscal policy, distance from initial trade shocks, and an eventual release of pent-up demand for cap-ex, consumption and housing investment. Zero population growth is an exaggerated shock as it is mostly due to temps.
The most likely CUSMA scenarios are a successful negotiation or a protracted period of annual reviews. The economy can adapt to either scenario. Almost 90% of Canadian exports to the US are tariff free and CAD has depreciated 16 cents from its 2021 peak.
Spare capacity is expected to be shut over our forecast horizon while supply side constraints and rising cost pressures merit continued caution on inflation risk.
Derek Holt, Canada 416.863.7707
NORTH AMERICA
MAJOR CURRENCIES
MAJOR CURRENCIES (continued...)
LATIN AMERICA
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FOREIGN EXCHANGE STRATEGY
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Scotiabank, together with “Global Banking and Markets”, is a marketing name for the global corporate and investment banking and capital markets businesses of The Bank of Nova Scotia and certain of its affiliates in the countries where they operate, including; Scotiabank Europe plc; Scotiabank (Ireland) Designated Activity Company; Scotiabank Inverlat S.A., Institución de Banca Múltiple, Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Casa de Bolsa, S.A. de C.V., Grupo Financiero Scotiabank Inverlat, Scotia Inverlat Derivados S.A. de C.V. – all members of the Scotiabank group and authorized users of the Scotiabank mark. The Bank of Nova Scotia is incorporated in Canada with limited liability and is authorised and regulated by the Office of the Superintendent of Financial Institutions Canada. The Bank of Nova Scotia is authorized by the UK Prudential Regulation Authority and is subject to regulation by the UK Financial Conduct Authority and limited regulation by the UK Prudential Regulation Authority. Details about the extent of The Bank of Nova Scotia's regulation by the UK Prudential Regulation Authority are available from us on request. Scotiabank Europe plc is authorized by the UK Prudential Regulation Authority and regulated by the UK Financial Conduct Authority and the UK Prudential Regulation Authority.
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Not all products and services are offered in all jurisdictions. Services described are available in jurisdictions where permitted by law.