The Canadian Dollar Steadies but Outlook has Deteriorated says Scotiabank

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- CAD stabilises above 1.30 as USD weakens amid global rout.

- But relative interest rate outlook has deteriorated says Scotiabank.

- Oil and housing market developments pose risk to BoC policy outlook.

Canada's Dollar appeared to stabilise Thursday amid a rout in financial markets that has forced the U.S. greenback onto its back foot, although analysts at Scotiabank are saying the outlook for the Loonie has deteriorated of late.

Scotiabank's call comes on a day when the greenback is in retreat following a rout in bond prices that spooked stock markets across the globe, leading the carnage to spill over into currency markets.

This has provided breathing space to the Loonie by stemming an earlier decline that had seen the USD/CAD rate cross over a key technical level, which some saw as likely to encourage further losses. 

The Toronto-headquartered lender's currency team says the technical picture is now neutral for the USD/CAD rate but that there are a range of fundamental factors that may pose as headwinds to the Canadian Dollar over coming days. 

"The outlook for relative central bank policy has deteriorated on the back of worrisome oil price developments and this week’s disappointing housing data. Yield spreads have widened in a CAD-negative manner and the price of Western Canada Select has extended its decline to fresh two year lows nearing $25/bbl," says Shaun Osborne, chief FX strategist at Scotiabank. 

Canada's largest single export is oil and although the rise in prices of most kinds of crude has been hansom this year, events in the domestic market have been less than supportive of the Loonie. 

Western Canada Select prices have fallen to a two-year low near $25 in recent weeks while West Texas Intermediate prices reached a two-year high of $76.90 at the beginning of October. WTI was quoted at $71.77 Thursday.  

"The discount of Western Canada Select (WCS) to WTI is now around $40. Empirical studies show that when the WCS-WTI discount is less than $25, the average 100-day correlation is a respectable 0.52. That compares to a weaker average correlation of 0.24 when the discount is greater than $25," explains Bipan Rai, a strategist at Toronto-headquartered CIBC Capital Markets, in a recent note to clients.

Canada's oil trades at a steep discount to the U.S. benchmark in part due to differences in thickness and quality of the raw product produced north of the border, but also because of a "dearth" of pipeline capacity to facilitate the transfer of oil to refiners in offshore markets. 

This leaves Canadian producers with little choice but to sell their oil to the U.S., almost always at a steep discount to world market prices, according to a report by JWN Energy. Canada's government had been attempting for some time to build a new pipeline called "Trans Mountain" that it claimed would enable the nation to export more oil to international markets.

It was expected that widening the pool of available export opportunities would support investment and jobs within the energy sector as well lead to an increase in the price of Western Canada Select that would then benefit the government finances and Canadian Dollar.

However, Canada's supreme court sided with environmentalist and indigenous opponents of the project in a recent ruling and the government now appears to have abandoned the idea, darkening the outlook for Canadian business investment, oil prices and the Loonie.

That is negative for currency markets that are looking to see signs of rising domestic demand that supports the inflation outlook and adds to the case for the Bank of Canada (BoC) to keep on raising its interest rate.

September's decline in new housing starts has also got Scotiabank's Osborne and some other analysts nervous about the Canadian economic outlook and its implications for the Bank of Canada.

"The slowdown in building has coincided with moves toward more restrictive mortgage rules and higher interest rates, and is in line with our below-consensus outlook for housing starts over the second half of 2018. As these forces continue to weigh on the housing market, we see residential investment turning from a boost to a drag on GDP in 2019," says Royce Mendes, an economist at CIBC Capital Markets. 

The market implied interest rate for the BoC's October 24 meeting is around 1.72%, up from just 1.64% at the beginning of September, while the rate implied for January 09 has moved from 1.84% to 1.94% during the same time.

The current cash rate is just 1.5%, so the above pricing suggests investors will already have taken the BoC's next two likely rate hikes to the bank.

"Broader developments are set to remain dominant ahead of Monday’s Bank of Canada Business Outlook Survey, a key consideration for policymakers heading into the October 24 rate decision and MPR forecast update. Measures of implied CAD volatility are rising broadly and lifting the premium for protection against CAD weakness," says Scotiabank's Osborne.

For Bank of Canada policy to support the Canadian Dollar over coming months the economic outlook needs to evolve in  a way that is conducive to the central bank continuing to hike after January 2019. And Osborne's view on that subject is one of doubt and caution.

The USD/CAD rate was quoted 0.08% lower at 1.3040 Thursday but is up more than 3% for 2018, while the Pound-to-Canadian-Dollar rate was 0.81% lower at 1.72 but is up 1.5% this year.

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