Canadian Dollar: Economy Likely Stalled in August but Loonie Outperformance Set to Continue

Image © Pavel Ignatov, Adobe Stock

- Growth stalled in August but outlook is still bright says ING.

- Economy to grow 2.6% for 2018, keeping the BoC on its toes.

- CAD set to hold own against USD, prevail over other currencies.

The Canadian Dollar is likely to outperform many of its G10 rivals over coming weeks, according to analysts, even if official data reveals the Canadian economy ground to a halt in August. 

Consensus is for the Canadian economy to have grown by 0.1% in August, down from 0.2% in July, although this should still leave the annualised pace of growth unchanged at 2.4%.

Strong growth in export volumes, which rose at their fastest pace for four years in June, may well be behind the market's optimistic outlook for the latest Canadian economic figures. 

However, analysts at ING Group say the economy most likely stalled during the August month, with GDP registering a 0% change as waning consumer spending and weak wholesaling activity weighed on the economy.

"July’s GDP print (0.2% MoM) was slightly better than we expected, but we're not expecting any surprises to the upside for August - in fact, we see a flat monthly figure. This shouldn’t take the shine off things as the growth story in Canada has shown underlying momentum throughout summer," writes James Knightley, chief international economist at ING, in a note to clients. 

Canada's GDP number will be released at 13:30 London time Wednesday. And despite low expectations this time, Knightley says the outlook for Canada's economy remains bright, with GDP likely to have risen 2.6% for 2018 overall.

That is only a fraction below the 3% growth seen in 2017 and is notable given the uncertainty that hung over the economy like a Damocles Sword through much of the current year, given President Trump's now-completed push to renegotiate or terminate the North American Free Trade Agreement. 

Currency markets care about the GDP data because economic growth has a direct bearing on inflation and it is changes in consumer price pressures that central banks are attempting to manipulate when they tinker with interest rates, which are themselves the raison d'être for most swings in exchange rates.

"Consistently good growth numbers support the notion that Canada’s economy is tracking close to potential. This is putting upward pressure on prices – with a particular focus on the (less-volatile) core measures which currently average the banks 2% inflation target. The central bank remains upbeat that their tightening path will continue and we forecast two more hikes in 2019," Knightley says. 

The Bank of Canada (BoC) raised its main interest rate by 25 basis points to 1.75% in October, the third rate hike in 2018, and signalled that further rate hikes will follow over coming months. 

It said the cash rate will have to rise all the way up to the so called "neutral" level, which it estimates to be between 2.5% and 3.5%. 

The "neutral" rate of interest is the equilibrium level at which rates themselves neither encourage nor restrict economic activity. It is not fixed at a particular point and policymakers do not know exactly where it is at any one point in time.

This means the Loonie will continue to benefit from rates that are rising at a time when other central banks are sat on their hands.

Changes in interest rates are only normally 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.

The USD/CAD rate was quoted 0.07% higher at 1.3136 Tuesday and is up 4.4% for 2018 while the Pound-to-Canadian-Dollar rate was 0.40% lower at 1.6741 and has declined 1.16% this year.

"Solid Canadian data may help to keep a lid on USD/CAD below 1.32 - we would look to fade any move above as it would appear out of sync with relative US/Canadian fundamentals," says Viraj Patel, an FX strategist and ING colleague of Knightley. 

Canada's close proximity to the roaring and stimulus-backed economy of the U.S. is another factor that can support the Loonie against its G10 counterparts over coming weeks and months. 

Both Canadian and U.S. economies are growing at rates close to 3% and inflation in each country is running close to official target levels, enabling both major North American central banks to keep raising interest rates.

"We think CAD will continue to outperform most other currencies due to its close alignment with the USD. We have USDCAD roughly flat at 1.30 on a 3M horizon before falling to 1.28 on a 6M horizon and 1.25 on a 9M horizon," says Greg Anderson, head of FX strategy at BMO Capital Markets. 

The Federal Reserve and Bank of Canada are raising rates at time when economic growth in Europe has fallen back below the 2% level and both the European Central Bank and Bank of England are being stymied from raising rates by low inflation and the ongoing Brexit negotiations respectively. 

Meanwhile central banks in the Antipodes, despite presiding over economies that are still growing at a robust pace, are being prevented from lifting their own interest rates by persistent below-target inflation.

That has contributed to severe losses of -8.9% and -7.4% respectively for the Australian and New Zealand Dollars in 2018.

All of this means the international environment is a fertile one in which the Canadian Dollar could well outperform many of its developed world rivals. 

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