The Canadian Dollar is Running Out of Gas, CIBC Forecasts

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- CAD seen running out of road, tipped by CIBC to fall.

- As BoC rate cut is on way and markets are unprepared.

- USD/CAD seen higher at year-end, GBP/CAD seen lower.

The Canadian Dollar was higher against most rivals Thursday amid another bump in oil prices but is fast running out of road, according to economists at CIBC Capital Markets, who're tipping the Loonie to fall before year-end and continue depreciating throughout 2020. 

Canada's Dollar remained the best performing major currency for 2019 Thursday but now faces an obstacle in the form of the Bank of Canada (BoC). CIBC says the BoC is now likely to cuts its interest rate in December, which is a move that financial markets are unprepared for and that would likely engender weakness in the Canadian Dollar as a result. 

"We’re sticking with our call for a lone quarter point cut from the Bank of Canada, and while we merely nudged that a month earlier (to December), market expectations have swung more wildly, initially having bet heavily on an October cut, but subsequently dropping odds for a cut at all this year," says Avery Shenfeld, chief economist at CIBC, in a review of its forecasts.

The BoC came across much less concerned about the economic outlook than some in the market had anticipated it would when the bank outlined its reasons for leaving the cash rate unchanged at 1.75% in September, leading investors to cancel earlier bets that had envisaged it cutting rates in October.

Above: USD/CAD rate shown at daily intervals.

Governor Stephen Poloz did warn again that economic growth will likely slow in the second half of the year but he also explicitly tied forthcoming interest rate decisions to developments in the U.S.-China trade war which, if anything, have been positive ever in wake of the September 05 decision. Since then, both the U.S. and China have exempted some of each other's products from new tariffs announced in August while delaying the implementation of other levies and agreeing to hold talks in October. 

Market speculation is that those talks could lead to a 'mini deal' that either ends, or at the very least suspends, the trade war between the world's two largest economies. That tariff fight has been running for more than a year and has already badly hurt the global economy, while the BoC has long warned the conflict will make its mark on the Canadian economy sooner or later. 

"While inflation continues to meet the BoC’s target, and Q2 GDP far surpassed the BoC’s forecast, the details of the GDP release revealed a less resilient picture of cautious consumers and businesses, with notable worsening in business machinery investment from the previous quarter. Canada’s higher household debt levels and lower savings rate suggests consumption doesn’t have as much remaining firepower as it does in the US," Shenfeld warns. 

Much about the BoC interest rate outlook remains to be determined but many analysts are downbeat on the prospect of the U.S. and China reaching a lasting accord to end the dispute between them and many central banks across the developed world have already cut their interest rates more than once or taken other forms of radical action so as to guard their economies against a mounting global slowdown. The BoC is one of just a few exceptions. 

Above: Canadian inflation rates including and excluding gasoline. Source: Statistics Canada.

Most importantly the Federal Reserve, which the BoC has historically shadowed out of a reluctance to see exchange rate movements undermine its own inflation objectives, has now cut U.S. rates twice this year and markets aren't yet convinced that it's finished easing its policy settings. Shenfeld says the BoC will soon follow suit with its own cut but pricing in the overnight-index-swap (OIS) market implied on Thursday, a December 04 cash rate of 1.68%. 

The OIS-implied cash rate is still substantially above the 1.5% rate that would prevail if the BoC announced a standard 25 basis point cut and suggests that neither the interest rate market, nor the currency market, is prepared for such a move. That means the Canadian Dollar would be likely to suffer if a rate cut was announced Thursday.

"A rate cut either delivered or strongly hinted at in December should see the dollar-Canada hovering near 1.33 at year end and into H1 2020," Shenfeld says. "Look for a depreciation in the C$ over the course of 2020 and into 2021, reaching 1.38 by Q4 2020."

Changes in rates are normally made in relation to the outlook for inflation, which is sensitive to economic growth, but impact currencies because of the influence they have over capital flows and decisions of short-term speculators. Capital 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. Rising rates have the opposite effect.

Inflation fell by 0.1% in August, dragging the annualised figure down from 2% to 1.9%, while the BoC's three alternative measures of 'core' inflation continued to average the 2% target in August. However, those inflation rates would likely fall if the economy slows, potentially necessitating rate cuts so as to ensure the consumer price index remains at the 2% target. The BoC downgraded its inflation forecasts this month, and now sees the consumer price index below 2% at least until the end of 2021.

Canada's economic and financial stars appear to be aligning in a manner that suggests the BoC will join its developed world peers in cutting rates sooner rather than later, which would be harmful to the Loonie because it's the bank having stood apart from the crowd this year that has boosted the attractiveness of Canadian government bonds and seen investors flock toward the currency as a result. In other words, it was the BoC that put the Loonie at the top of the major currency league table and if Canada's Dollar is to be knocked off its perch at all, it will be the BoC that does the deed.

CIBC forecasts the USD/CAD rate will rise to 1.33  by year-end, 1.34 by June 2020 and 1.38 before the curtain closes on the next year. The Pound-to-Canadian-Dollar rate is forecast to fall from 1.66 Thursday to 1.59 by year-end, before rising to 1.86 before the curtain closes on 2020.  

"The economic backdrop in the UK will continue to weigh on Sterling in the very near term. Recession risks are elevated as consumer confidence remains compromised and business investment constrained. Signs of a slowdown in the labour market are starting to materialize, as vacancies have retreated to a two-year low and hours worked, often a precursor to job losses, fell. Add to that the risks of an election that markets fear could install an extreme left government, and there are reasons to stay cautious on the GBP through year end even if the PM gets his deal with Europe," says Bipan Rai, head of FX strategy at CIBC.

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