Canadian Dollar is 5% Overvalued: BofA

The Canadian Dollar is looking pricey at current levels argues fresh research into the currency.

John Shin at Bank of America Merrill Lynch Global Research has written to clients suggesting that the Canadian Dollar could be as much as 5% overvalued against its US cousin,

In a note dated April 3 Shin says he has modelled the Canadian Dollar’s value against oil prices and the difference in interest rates between the US and Canada to arrive at the conclusion.

Rate Differentials Matter More than Oil

Bank of America combine both oil and rate differentials into a single model of USDCAD relying on a rolling regression with a five year time window on monthly data.

Analysts have arrived at a “distinctive result” about combining oil and rates:

“The rate differential has turned out to be unusually strong in driving CAD, relative to the impact from oil prices, and has been unusually important in these past few months.”

“It is from our previous estimates where we calculate that CAD is around 5% overvalued given the current state of rates and oil, which is consistent with our forecasts.”

In fact, different specifications point to even more of potential overvaluation.

“Still, over the rest of the year, oil prices remain the key risk to our CAD forecasts, given that we continue to look for CAD to weaken, despite our commodities outlook staying the same,” says Shin.

The Canadian side of the rate differential still points to a Bank of Canada (BoC) that remains firmly on hold, as is Bank of America’s forecast for this year.

This is in turn said to be supportive of a higher USD-CAD.

At the BoC's last interest rate announcement on March 1st, they strongly signalled they would not be moving anytime soon, and if anything, struck a dovish tone.

When asked at a press conference on March 28th about rate hikes, Reuters reported that BOC governor Stephen Poloz said that "if we were to raise rates back to normal prematurely, like today, the economy would, I'm certainty, have a recession."

“Presumably a weaker CAD would likely fit into Poloz's macro preferences at the moment,” says Shin.

BofA Forecasts for the Canadian Dollar

Bank of America are still looking for USD/CAD to finish the year at 1.39.

“Such a forecast is directionally the same as the market, although consensus expectations look for a more modest smaller upside for USD-CAD. However, we also note that we continue to expect USD-CAD to largely reverse the move next year on these same factors,” says Shin.

Risks: US corporate Income Tax Reform

A potential risk to the Canadian Dollar’s expected trajectory is the prospect for notable changes to US corporate and income tax reform.

“Although markets have become more skeptical after the failure of the repeal of the Affordable Care Act. Installing a border adjustment would likely cause us to reconsider USD-CAD significantly to the upside in that event,” says Shin.