Canadian Dollar's Rally Set to Stall as Economic Concerns Emerge, says MUFG Bank Research

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Despite a recent outperformance by the Canadian Dollar, a set of new forecasts show expectations for a steady decline in the Canadian Dollar's value against the U.S. Dollar, Euro and British Pound.

Investment bank MUFG says in a midyear exchange rate forecast update that the Canadian dollar - which experienced a robust rally in June - may be facing headwinds as economic concerns come to the forefront.

According to Derek Halpenny, Head of Research for Global Markets EMEA at MUFG Bank Ltd, this recent strength of the Canadian dollar was largely driven by the Bank of Canada's (BoC) decision to resume its tightening cycle.

However, incoming data indicating labour market weakness and a notable decline in inflation have raised doubts about the sustainability of the Canadian dollar's rally.

Halpenny points out that the shift in market expectations regarding the BoC's monetary policy played a significant role in driving the Canadian dollar's appreciation. The 2-year US-CA spread, which measures the yield differential between the two countries, experienced a substantial move of close to 100 basis points from its peak in March to its low in June.

While initially USD/CAD did not respond to this shift, the Canadian dollar started to appreciate notably from late May, climbing from levels above 1.3600.

The BoC's decision to tighten monetary policy was prompted by data showing economic resilience.

"However, recent indicators have revealed weaknesses in the labour market, with a significant drop in full-time employment by 32.7k in May. Moreover, the battle against inflation has seen a substantial fall in headline Consumer Price Index (CPI), with the BoC's Median CPI and Trimmed CPI also experiencing declines," says Halpenny.

MUFG Bank's research suggests that the Canadian dollar's performance is also influenced by the ongoing resilience of equity markets.

However, there are concerns of a potential correction to the downside, which could start to weigh on the Canadian dollar.

Above: CAD performance in 2023.

According to MUFG, historical trends in CAD movement indicate that during US recessionary periods, the Canadian dollar tends to weaken. Given the strong inter-linkage of the Canadian economy with the US, expectations of weaker growth in Canada are likely to intensify, putting downward pressure on the Canadian dollar.

Considering the recent significant drop in USD/CAD, MUFG Bank has adjusted its forecast profile to show a clearer path for the US dollar's appreciation against the Canadian dollar.

Analysts at the Canadian lender believe that the current levels of CAD strength may have reached their limits, indicating a potential reversal in the Canadian dollar's rally.

The Dollar-Canadian Dollar exchange rate is forecast to end the third quarter at 1.3100, the final quarter of 2023 at 1.32 and the first quarter of 2024 at 1.35.

The Euro-Canadian Dollar exchange rate is forecast to be at 1.4410, 1.4780 and 1.5140 at these respective time points.

For the Pound-Canadian Dollar exchange rate, the forecast profile is 1.6666, 1.68 and 1.7146.