Canadian Dollar Outlook: Be Cautious says Credit Suisse

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Be cautious when chasing the Canadian Dollar higher says a leading foreign exchange strategist, a warning that if correct suggests one of 2021's winners won't deliver a repeat performance in 2022.

Foreign exchange strategists at Credit Suisse are cautious on the Canadian Dollar, saying the Ontario lockdown means the market is overestimating the prospect of a January rate hike at the Bank of Canada.

And a Bank of Canada disappointment is all the more likely as Canadian inflation dynamics are anticipated to disappoint relative to those in the U.S., warns the Swiss-based investment bank.

"We think caution is warranted in going long CAD at current levels," says Alvise Marino, Director of FX Strategy at Credit Suisse.

In a research briefing out at the start of 2022 Credit Suisse says they are looking to fade any strength in the Canadian Dollar as a result.

Researchers find a market consensus expects the Canadian Dollar to maintain its winning ways in 2022 following a strong performance in 2021.

"While the early days of 2022 have seen a proliferation of sell side long CAD recommendations, we do not see an urge to change our view for now and even argue that potential for near-term CAD outperformance vs fellow cyclical currencies might be more limited than we had previously expected," says Marino.

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There are some idiosyncratic risks behind this stance, particularly with regards to the response by authorities to the arrival of the Omicron variant in Canada.

"The introduction of a stringent lockdown in Ontario on 3 Jan is an important risk ahead of the 26 Jan BoC meeting, for which markets are pricing in already a 40% probability of a 25bp hike," says Marino.

The development puts at risk a consensus expectation that the Canadian Dollar will outperform as the Bank of Canada would shy away from raising interest rates later in January.

Ontario introduced a new lockdown on January 03 as authorities anticipated a surge in Omicron-related hospitalisations.

The lockdowns saw the banning of indoor dining, social distancing in retail stores restrictions placed on social gatherings.

Schools moved online and workers required to work from home, with the lockdown anticipated to last until January 26.

"In the current G10 context, this set of measures represents a particularly aggressive reaction to the Omicron threat, one that has the potential to disproportionately weigh on the Canadian growth outlook, at least compared to fellow G10 peers where similar measures would be considered politically unfeasible, or are seen as no longer urgent," says Marino.

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Credit Suisse finds market pricing for the Bank of Canada’s interest rate policy is the second most aggressive in G10, leaving scope for disappointment.

A key theme driving markets in 2022 will be central bank normalisation; the process whereby central banks raise interest rates and reverse their pandemic-era quantitative easing programmes.

This raises the yield paid on government bonds and raises the cost of financing.

Those countries that take the lead would be anticipated to see their currencies advance relative to the laggards.

Therefore if the Bank of Canada's normalisation timeline is pushed back the Canadian Dollar could face headwinds.

OIS markets - a gauge of how how investors are anticipating interest rate moves - show as many as 140 basis points of hikes are expected to come out of the Bank of Canada in 2022.

Credit Suisse says this contrasts hawkishly with the 86bp say they are anticipated from the Federal reserve, 104 points from the Bank of England and 104 from the RBA.

The Reserve Bank of New Zealand however leads the pack with 156 points anticipated.

"The fact that so far only Canada implemented aggressive restrictions related to Omicron (even if at the provincial and not federal level) can in our view represent an obstacle to further strength in priced-in tightening expectations," says Marino.

The Bank of Canada will meanwhile also be constrained by inflation dynamics: common core CPI - the inflation metric that the Bank focuses on most directly - was still 2.0% year-on-year in November, in line with their target and below comparable U.S. core CPI metrics.

Marino says this introduces the possibility of an idiosyncratic slowdown in growth is an important development in a context where inflation data and expectations alone are already relatively less supportive of rate hikes than they are in the U.S.

"All things equal, this leaves CAD relatively constrained," says Marino.