Canadian Dollar Eyes Support from Bank of Canada but Local Oil Price Developments Threaten Outlook

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- CAD remains on front foot as market eyes Bank of Canada.

- BoC to hike on Oct 24, four times in 2019, say J.P. Morgan.

- But domestic oil market developments a threat to the CAD.

The Canadian Dollar is on its front foot as traders continue to cheer an improved outlook for Bank of Canada interest rate policy but both could be put at risk by developments in the domestic oil market if prices remain where they are, according to some analysts. 

Canada's Dollar has been granted a period of stability in the last month after negotiators from across the region reached a deal to save the North American Free Trade Agreement, which has been renamed the U.S.-Mexico-Canada-Agreement, from President Donald Trump's America First agenda. 

And now with the threat of a return to the pre-NAFTA era no longer hanging over the Loonie's head, analysts are once again focused on the outlook for Canadian interest rate policy and its implications for the differential between bond yields North of the U.S. border and those elsewhere in the world. 

"October 24 will mark the BoC’s first meeting in the post-USMCA macro environment," says Daniel Hui, an analyst at J.P. Morgan. "We expect the Bank to hike this month, in addition to hiking four more times in 2019, as the BoC’s measure of core inflation touched 2.0% for the first time since 2012 in August and is facing increased capacity constraints."

The Bank of Canada has cited the prospect of a U.S. withdrawal from NAFTA as a siginificant risk facing the economy that could lead to slower growth and weaker inflation.

This will have meant lower interest rates over coming years than otherwise would have been the case, which would have dealt a blow to the Loonie in a world where global interest rates are rising. 

"This [October] hike was already well anticipated by markets even before the USMCA breakthrough (80% priced before, 90%+ priced now), so it is the forward looking rhetoric that might imply future pace and terminal rate that is more important for markets to monitor," says Hui. 

Already the BoC interest rate is at 1.5%, which is higher than all but three G10 interest rates, and is expected to go to 1.75% on October 24. 

Changes in interest rates are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

If the Canadian economic picture develops in such a way that it justifies a continued gradual tightening of monetary policy over coming quarters, then the Canadian Dollar may be have scope to rise steadily against many of its rivals.

However, developments in the domestic oil market could scupper the BoC and Canadian currency, particularly if current price levels are sustained for much longer. 

"One particular headwind specific to Canada is that Western Canada Select crude prices are trading at near-historic lows," says Hui. "This sharp fall in oil prices could be material for CAD if it persists, given that the decline in WCS crude, compared to the average 2018 WCS price ($42.42) into our short-term fair value model, is worth almost two cents on USD/CAD fair value."

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 $71.15 Tuesday.

Canadian oil has always traded at a steep discount to WTI and global prices for a variety of reasons, although this discount has widened to more than $40 in recent weeks due to inneffective government policy north of the U.S. border. 

Now, prices are at such low levels that they could endanger business investment and jobs in an oil industry that is crucial to Canadian employment and economic growth. 

Should prices remain where they are analysts would likely mark down their estimates of "fair value" for the Canadian Dollar.

This is while signs of an oil-driven economic slowdown emerge over coming months could easily throw the Bank of Canada off course, which would also be bad for the Loonie. 

For now though, the J.P. Morgan team at least, say the Canadian Dollar will likely continue to trend higher. Eventually falling within the 1.2550 to 1.2775 range. 

The USD/CAD rate was quoted 0.22% lower at 1.2964 Tuesday but is up more than 3% for 2018, while the Pound-to-Canadian-Dollar rate was 0.27% higher at 1.7138 but is up 1.2% this year.

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