Canadian Dollar Running Out of Road, as Economic Outperformance Fades

Image © Pavel Ignatov, Adobe Stock

- CAD now vulnerable to downward correction, says CIBC.

- Growth data to soften and challenge steady BoC narrative.

- CIBC says to sell CAD Vs non-USD currencies as Fed cuts.

The Canadian Dollar softened against its U.S. counterpart Tuesday but continued to trounce other rivals in the G10 league table, although the Loonie's dominance of the developed world currency universe could soon be undermined if the latest commentary from CIBC Capital Markets is anything go by.

Canada's Dollar has risen sharply against all of its rivals this year but particularly struggline European currencies like the Euro, Pound Sterling and Swedish Krona. And it's some of those units that could experience the most significant rebounds over the coming months if CIBC Capital Markets is right. 

"The CAD has been the darling of the FX markets this year," says Bipan Rai, head of FX strategy at CIBC, in a note to clients. "We’ve got at least five reasons to doubt whether the CAD will continue its hot streak, plus a few strategies to capitalize on CAD weakness going forward." 

This year's gradual pivot by the Federal Reserve, from a rate-hiking stance to one that suggests it's about to cut U.S. interest rates steeply, has been a boon for the Canadian Dollar because it's sent most other central banks into easing mode themselves. Not the Bank of Canada (BoC) though. 

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

Canada's economy has appeared to stand apart from the crowd in recent months after growth was seen rebounding from an earlier slump at the beginning of the second quarter, and given how the labour market has continued to create new jobs and inflation has risen. 

That's left the BoC little choice but to indicate it'll stand pat, leaving its cash rate unchanged at 1.75%, in the months ahead and to watch the Loonie appreciate as a result. But CIBC says Canada may have just been behind the rest of the class in exhibiting signs of renewed weakness.

"CAD data has done well relative to expectations over the past few months. And naturally, there’s a tendency to bet on momentum and extrapolate further strength," Rai says. "It’s payback from weak showings in Q4 and Q1. Annualized growth for both quarters were 0.3% and 0.4% respectively, well below our estimate of trend growth which is around 1.8%. – Q2 data is currently tracking 2.6%, which is good enough to bump the trajectory back to trend. But beyond that? Things look a little dicey."

Rai says Canada's 'economic surprise index', which measures actual economic data points against economist expectations and the market consensus, has risen to a nine-year high since employment, inflation and growth data began to surprise on the upside last quarter.

However, this leaves the index and the Canadian Dollar vulnerable to a downward correction, which may already be underway considering the last two economic numbers from Canada have disappointed the market. 

Retail sales fell 0.1% in May, according to figures out last week, when markets were looking for a 0.3% gain. Sales suprised on the downside in April too, although the data was not released until the middle of June. Monday saw wholesale sales reported 1.8% lower in May, than they were back in April, adding to the earlier disappointment. This weakness in domestic demand is happening at a time when the global economy is also on its back foot. 

Above: USD/CAD rate shown at weekly intervals.

"The CAD is exposed to cyclical patterns in global growth and trade," Rai says. "The global trade environment is getting worse, not better. Protectionist barriers (such as tariffs and export restrictions) are going up. This isn’t an environment for the currency of a small, open economy to do well."

The BoC says the current 1.75% cash rate is "accomodative" for the economy and that it will pay particular attention to "developments in the energy sector and the impact of trade conflicts on the prospects for Canadian growth and inflation" when making future interest rate decisions. It raised Canadian rates three times in 2018 but has not budged once so far in 2019 and the bank is no longer telling markets that the next move in interest rates will be an upward one. 

BoC policymakers obliged to use interest rates to ensure inflation, which is sensitive to growth, averages around 2% over the medium term. Changes in rates impact currencies because of the influence they have over capital flows. Those flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. 

Inflation surged above the 2% target in May only to fall back toward the target in the subsequent month and with the economic outlook now souring, economists argue that inflation risk is to the downside. That's certainly the case for most other G10 economies whether in North America, Europe or elsewhere. 

"We don’t think the bank should cut just yet based on available evidence, but the risks clearly favour dovishness rather than hawkishness going forward. Keep in mind that Poloz didn’t endorse the notion that the next move would be a hike earlier this month (which is a departure from the April BoC). Juxtapose that with how the market is currently pricing the Fed and the higher bar for further dovish surprise south of the border," Rai warns. 

Above: CAD/NOK rate shown at weekly intervals.

Rai is concerned the Canadian Dollar could be found wanting in the wake of its recent gains if the Fed underdelivers against lofty market expectations of rate cuts in July and September. U.S. GDP data for the second quarter, due out on Friday, will provide insight into the odds of that happening. 

CIBC has recommended that clients use currency 'options' to exploit any possible increase in the USD/CAD rate over the coming weeks and is also a seller of the Loonie relative to the Norwegian Krone, which is the only other G10 currency to still have a central bank that is looking to raise its interest rate. 

However, CIBC's year-end forecasts still look for the USD/CAD rate to reach new lows this year before ending 2019 at 1.29. The Pound-Canadian-Dollar rate is seen remaining steady at around 1.6383 through the rest of the year.

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