The Canadian Dollar Is Now Tipped to Underperform as U.S. Outlook Sours

Image © Pavel Ignatov, Adobe Stock

- CAD advances after trade balance surprise offers support.

- But economists say the details of the report weren't pretty.  

- RBC and CIBC flag downside risks to CAD trade and growth.

- CIBC eyes CAD losses, cites correlation with ISM and S&P500.

The Canadian Dollar was lifted by better-than-expected trade figures and positive market sentiment Friday but is now being tipped to underperform as the U.S. economy softens and takes the Loonie down with it. 

Statistics Canada said Friday that Canada's trade deficit fell in August, from $1.4 bn to $955 mn, which was lower deficit than the $1.1 bn that markets had been looking for. Exports were up 1.8% that month, mostly due to increased shipments of energy and aircraft, while imports grew only 1%. 

Canada's Dollar welcomed the numbers no doubt because it was exports and activity in the oil sector that enabled the economy to outperform its rivals in the second quarter, but economists have got bones to pick over the details in the data. The Loonie scored its best gains over a Brexit-stricken Pound Sterling.

"Non-energy export volumes increased about 1% month-over-month by our count, but driven largely from an increase in exports of aircraft and other transportation equipment which grew by 13.2%. That increase is likely not to be repeated," says Rannella Billy-Ochieng’, an economist at RBC Capital Markets. "After accounting for price effects, energy exports were also down 2.2% in August...a pullback in equipment imports does not bode well for near-term business investment growth."

Above: Canadian Dollar performance Vs major rivals. Source: Pound Sterling Live. 

Canada's economy grew at an annualised pace of 3.7% in the second quarter, its fastest in years, which allowed the Bank of Canada (BoC) to leave its interest rate unchanged at 1.75% even as the Federal Reserve across the border, signalled a pause in its hiking cycle and eventually began cutting. 

The Fed has cut U.S. rates twice this year but the BoC says only that it's watching developments in the economy and will respond accordingly. Canada's economic resilience and the BoC's steady hand have driven the Loonie to the top of the developed world league table this year, but the outlook for all three of those things is now in doubt.

RBC's Billy-Ochieng says risks to Canadian exports are tilted to the downside, given the ongoing U.S.-China trade war and a continued slowdown in the global economy. And CIBC Capital Markets has flagged this week, the Canadian economy's close correlation with Institute of Supply Management Manufacturing PMI survey as reason for concern about the growth outlook. 

"There’s a relationship between US ISM and Canadian growth that goes back decades. Weakness in US ISM makes the CAD a high beta play potentially," says Bipan Rai, head of FX strategy at CIBC. 

Above: CIBC graph showing U.S. ISM manufacturing PMI correlation with Canadian GDP growth.

The ISM manufacturing PMI fell to its lowest level for a decade in September and the institute's sister survey of the U.S. services sector also plummeted Thursday. Both ask questions about activity, customer orders, employment and optimism about the outlook, although the results from all were decidedly dire and led economists to believe the U.S. could be headed for the rocks. Many now say the Fed may need to become more aggressive with its rate cuts. 

It may have even been Canada's proximity to the U.S., which was buoyed by tax cuts in 20218, that enabled the economy to do so well in the second quarter even as others including the U.S. decelerated. The jury is still out on that one but CIBC's Rai says that if the signal coming from the ISM surveys is true, then it will have adverse implications for the Canadian economy and for the Loonie. 

"The relationship between CAD and equities has increased over the last few months. There’s a bit of narrative-fitting here, but we think that is largely due to concerns regarding broad trade dynamics and the pass through to the health of the manufacturing sector. But it’s not just sensitivity to global risk sentiment – it’s also sensitivity to US economic sentiment," Rai says, in a note to clients.

Rai says it could be this relationship that explains why the Canadian Dollar has recently stopped responding to movements in the so-called rate spread, which is the difference between short-term bond yields in the two economies. Those are driven by the bilateral interest rate differential and currencies normally tend to follow them but the Loonie stopped following its rate spread in August. 

Above: USD/CAD rate at daily intervals alongside U.S.-Canada 'rate spread' (yellow line, left axis)

Since August the so-called rate spread has moved further in the favour of the Canadian Dollar because U.S. bond yields have fallen more than their Canadian counterparts, mostly due to the souring economic outlook across the border, and resulting pickup in market expectations for Fed rate cuts. Financial markets are now betting the Fed will cut U.S. rates as many as four times in the next 12 months, but barely price-in one solitary cut from the BoC in all that time. 

For two economies whose fortune is so closely intertwined, that divergence of expectations for interest rate cuts should be unsustainable. Rai and the CIBC team are arguing that it is unsustainable and that it'll be Canadian bonds and the Loonie that give way in order to correct it. However, there's another reason they're expecting the Canadian Dollar to decline in the months ahead, which is the Loonie's recently developed strong correlation with the U.S. S&P500. 

That stock index has a significant exposure to U.S. and global economies, both of which are under pressure from the trade war with China, which is itself hurting. But that benchmark of companies has risen 17% in 2019 and might not take a U.S. economic downturn very well, especially if a downturn happens with the global economy already in the mire. In other words, if the S&P500 cracks for any reason in the months ahead, it could take the Canadian Dollar down with it.

"CAD should continue to underperform as risk sentiment, position squaring and seasonality should continue to drive USD/CAD. – Also, we’re expecting the Bank of Canada to ease in the coming months and we haven’t seen the market price that in yet. The Fed is likely to expand its balance sheet as well which means that this correlative regime between front-end spreads and USD/CAD could remain in place...we have a 1.37 trade target by end of year," Rai says. 

Above: CIBC table of Canadian Dollar drivers on scale of 0.0-to-1.0. 

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