The Canadian Dollar's Inflation Boost Fades after Methodology Change Seen Behind December Rise

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- Inflation surprises on upside for December after methodology change.

- Increase gives supplements an earlier oil price-related boost for CAD.

- 2019 oil recovery to drag USDCAD even lower says Commerzbank.

The Canadian Dollar spiked higher Friday after official data revealed a surprise pick up in inflation during December, only to hand back gains shortly after as it emerged methodology changes were behind the increase, leaving the Loonie subject to the whims of energy prices.

Inflation fell by just -0.1% during December when markets had looked for a second consecutive -0.4% decline as the last of the final quarter's 30% decline in oil prices worked its way through into the cost of gasoline at fuelling stations. 

This was enough to push the annual rate of inflation back up to 2% when economists had been looking for it to hold steady at 1.7% in December. Core inflation, which excludes volatile items like gasoline from the goods basket measured, fell by a steeper -0.2%.

Meanwhile the Bank of Canada's (BoC) own three measures of core inflation continued to average 1.9% for the December month, unchanged from the level seen back in November. 

"Headline inflation bucked expectations for a soft print, but only because of a recent methodology change to the way airline fares are calculated," says Royce Mendes, an economist at Toronto-headquartered CIBC Capital Markets. "According to the new methodology, airline fares were up 22% on the month."

Markets care about the inflation data because it has significant influence over Bank of Canada interest rate decisions, which are the raison d'être for most moves in exchange rates.

Changes in rates are normally only made in response to movements in inflation but impact currencies through the push and pull influence they have on capital flows as well as their allure for traders.

"The methodology change is only exacerbating seasonal trends, and will therefore likely be reversed in January," Mendes predicts. "All told, the loonie is rallying off the higher than expected headline, but could come back after investors digest the details."

Above: USD/CAD rate shown at daily intervals alongside WTI oil price (orange).

The USD/CAD rate was quoted -0.18% lower at 1.3256 following the release after extending an earlier -0.10% decline. It has now fallen -2.55% this year.  

Oil futures prices rebounded out of an earlier trough Friday, with WTI crude up 1.59% during the London morning. With the difference between Western Canadian Select and WTI narrowing of late, the Loonie's has regained its correlation with the North American oil benchmark. 

"Resistance at 1.3323 remains in place as a topside hurdle for USD/CAD, with 1.3255 and 1.3227 serving as initial support," says Adam Cole, chief FX strategist at RBC Capital Markets.

The Pound-to-Canadian-Dollar rate was -0.54% lower at 1.7152 after extending an earlier -0.40% decline. It has fallen -1.44% in 2019.

"GBPCAD is firmer but there is little sign of a strong trend developing on the short, medium of longer run oscillators," says Eric Theoret, a technical analyst at Scotiabank. "More range trading is in store for GBP."

Above: Pound-to-Canadian-Dollar rate shown at daily intervals.

As a result, Canada's Dollar was quoted higher against most G10 currencies throughout the Friday session, but it remains to be seen whether the Loonie will be able to maintain this momentum for long. 

The Bank of Canada raised its interest rate three times in 2018, leaving it at its current 1.75% level, and had suggested back in October that it would lift borrowing costs all the way up to the so-called neutral level during 2019 and 2020. It estimates the neutral point is somewhere between 2.5% and 3.5%. 

But the bank began to back away from that guidance in December following a series of disappointing economic figures and a rout in oil prices that saw Brent crude swap a near 20% gain for a 10% annual loss in the final months of the year. It completed its retreat from that earlier position in January.

The new policy message, which has hurt the Loonie, is  that rates will still rise this year but that the bank will be more cautious going forward. In other words, it is likely to lift rates at a slower pace in 2019 than it did last year. 

"The risks to its outlook have increased significantly, which is why it has lowered its growth forecast for 2019 in the new Monetary Policy Report. The reason for this is the fall in oil prices, which will have an impact on the Canadian energy sector and private consumption," says Antje Praefcke, an analyst at Commerzbank. 

Praefcke and the Commerzbank team forecast the BoC will raise its interest rate on two occassions in 2019, taking it to 2.25% before year-end. They also say the slower pace of rate hikes should not have a lasting effect on the USD/CAD rate because the Federal Reserve has also moderated its policy ambitions too. 

As a result, what will matter most for the trajectory of the Loonie over the short term is the outcome for oil prices. Praefcke says a more supportive environment for oil will help drag the USD/CAD rate all the way down to Commerzbank's forecast of 1.22 in time for year-end. 

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