The Canadian Dollar Faces Growing Headwinds say TD Securities as Eyes Turn to Friday's Inflation Data Release

Expect further long-term strength in the USD to CAD exchange rate argue analysts but the near-term tone for the Canadian Dollar will be dictated by the release of August inflation data.

The Canadian Dollar continues to under-perform its commodity-currency counterparts, indeed, last week it sat alongside Pound Sterling as being the worst performing currency in the G10 bloc.

Of note, and discussed in a little more detail below, CAD appears to have detached itself from the oil price.

So any improvements in commodity and oil prices appear to have little impact on the currency.

Therefore, other issues have grown in importance, none more so than the question of interest rate settings at the Bank of Canada (BoC).

Low interest rates - not just in Canada but globally - are here to stay, according to the governor of the BoC, Stephen S. Poloz. 

Poloz made the remarks in a speech on Tuesday to the Association des économistes québécois, the Cercle finance du Québec and CFA Québec.

Rather than a purely economic phenomenon, low interest rates are the product of an ageing population, and the dampening effect this has on growth due to the fall in the share of economically active participants, added Poloz in his speech.

This intractable problem means that every small basis point of growth in the economy needs to be fought for.

Many analysts have taken Poloz's words as an indication he is willing to lower Canadian interest rates further. Typically lower interest rates result in a weakening of the domestic currency.

Recent disappointing growth data in Canada suggests that the expected bump from the government’s fiscal stimulus drive has not been as big as was expected.

Previous estimates that fiscal stimulus could do the heavy lifting of growth for the economy had supported the Canadian dollar as it was assumed there was less of a chance the BoC would need to lower interest rates or print money.

However, recent poor growth data seems to be saying that fiscal stimulus alone has been inadequate to the task of driving growth, and may need to be hand-held by further monetary measures too.

“It is quite evident that our economy is still facing strong headwinds, and we need stimulative monetary policy to counteract them and move us closer to full capacity. We also need to watch the full effects of the government’s fiscal stimulus unfold,” said Poloz.

A monetary stimulus renaissance would be likely to involve either the cutting of interest rates by the BOC from their current 0.50% or the introduction of quantitative easing (QE) in which the central bank buys bonds from financial institutions, both to provide them with liquidity and to keep rates low.

Both these measures are likely to have a negative impact on the Loonie in the months to come.

“Fed and the BoC policy divergence is likely to shift back on the markets radar screen next quarter. The catalyst for a weaker CAD could come from the BoC this time - who recently shifted to a dovish from neutral tone in light of a string of weaker data releases,” says Mark McCormick at TD Securities.

The falling influence of the price of oil as it settles in a range between 40-50 dollars per barrel is another reason to expect the interest rate differential to come back as a major driver for the pair, suggests McCormick.

Instead, the primary driver for USD/CAD appears to increasingly be data - negative data surprises for CAD and positive for USD appear to be correlating with the exchange rate.

“The result of this shift is likely to see a pickup in the correlation between USDCAD and data surprises as a reflection of the possible policy divergence over the coming few months,” says McCormick.

The chart above shows the increasing correlation of data surprises and the USD/CAD.

Data surprises are those which come out above or below market expectations.

Correlation is measured in a scale from -1 to +1, with zero equalling no correlation whatsoever, +1 equalling 100% correlation and -1 100% inverse correlation.

As can be seen on the chart the correlation between data surprises and USD/CAD has risen from zero in June (no correlation) to 0.25 in August (some correlation).

"The near-term risks favour USD/CAD downside if the Fed punts to December, but we see strong support near 1.2950. Even so, we still look for CAD weakness to persist in Q4 as headwinds are building," says McCormick.

Inflation Data Dominates CAD Outlook

Friday the 23rd of September is an important day for the Canadian currency with inflation data due for release.

Where inflation is headed will be important to the outlook at the BoC and therefore the CAD.

Should inflation come in below forecasts we could expect the BoC to lean harder on a desire to cut interest rates.

Consensus estimates are for a reading of 0.1%, anything below will likely pressure the currency.

"With the recent rejection of a key double top at 1.3219 keeping USD/CAD within a multi-month consolidation pattern, a re-test of the bottom end of this pattern (support near 1.2900) is expected to transpire," say RBC Capital Markets in a note to clients ahead of teh data release.