Further Significant Canadian Dollar Strength Unlikely: Analysts Cite Potential Housing Bust

The Canadian Dollar might have gathered as much impetus out of the Bank of Canada's current interest rate raising cycle as is possible.

The Canadian Dollar has been one of the best-performing global currencies over the course of the past month.

CAD is up 3.23% against the British Pound, 2.78% against the Euro and 4.74% against the US Dollar.

The rise has been fuelled by a series of interest rate rises at the Bank of Canada (BoC), the latest coming mid-week when the basic interest rate was lifted to 1.00%.

Raising the cental bank interest rate raises the yield on Canadian bonds which in turn attracts global capital inflows as investors seek out greater returns. But, the dynamics are nuanced.

"Markets price in expectations so you have to be early. By the time the actual interest rate tightening is delivered, most of the FX move has already happened. Canada is a perfect example," says analyst David Bloom at HSBC.

Rates markets are now pricing in nearly three more hikes by the end of 2018, but Bloom reckons, "It is more difficult to make the case for significant CAD strength from here when we have already seen a sizeable move and more rate hikes are in the price."

HSBC believe there are further gains to be had, but they will be limited when contrasted to what has already come.

Bursting of the Housing Bubble

The Canadian Dollar could see a change of fortune during the year ahead if the BoC reverses its recent policy tightening, as Capital Economics has predicted it will.

After house price growth reached high double digit rates during the summer, Capital Economics has flagged that Canada’s real estate market is showing signs of a cyclical turn.

“We expect GDP growth to slow sharply next year, prompting the Bank of Canada to reverse its tightening cycle,” says Paul Ashworth, chief North American economist at Capital Economics.

The Canadian Dollar set a fresh two year peak against the greenback earlier this week and came close to a four year high against the Pound Sterling after the Bank of Canada surprised markets by announcing another hike to its main interest rate.

Its move came after data showed the Canadian economy growing much faster than was previously expected at the end of the second quarter, with GDP expanding at an annualised pace of 4.5% in June.

But, the housing sector is where concerns are to be found.

“After a strong growth performance so far this year, Canada’s economy looks on the verge of a downturn as the housing boom turns to bust,” Ashworth wrote in a note this week.

House prices are rising at around 14% on an annualised basis; the last time we saw this kind of growth was back in 2007 - the year before the great financial crisis which was sparked by the collapse in the US subprime housing sector.

HSBC's Bloom is also wary of Canada's housing market.

"Canada’s household debt levels are high and while raising rates can temper the demand for
more debt, it might also prove the catalyst for a destabilising correction in house prices," says Bloom.

HSBC reckon a tightening in Canadian monetary conditions delivered through a stronger exchange rate may have less adverse implications for financial stability than a tightening via higher interest rates.

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Canadian Dollar to Correct Lower

“After the BoC’s second consecutive rate hike this week, our economists suspect there will be a pause in monetary policy. We tend to agree,” says Viraj Patel, a foreign exchange strategist at ING Group.

Canada’s central bank has now fully reversed all of its earlier policy response to the downturn in commodity prices, which hit the economy through 2014 and prompted rate setters into action during the subsequent year.

The BoC pushed through its first interest rate hike for seven years back in July and, this week, cited stronger than expected growth in Canada and what it described as more synchronous global growth as being behind its decision to hike again.

“We only see downside risks to the market pricing of 70bp of BoC hikes over a 1Y horizon. It’ll only take the sightless whiff of weakness (ie, signs of greater slack) in today’s August jobs report to see the CAD correct lower,” says Patel.

Relief for the Pound?

Canada’s central bank has moved onto a hawkish footing at a time when the Pound Sterling is facing multiple headwinds.

UK consumer spending has slowed during the year to date, something that weighed around the ankles of the economy in the first two quarters, while recent data has suggested that exporters of goods and services are yet to see a meaningful boost in activity coming from the a weaker Sterling.

Strategists at Commonwealth Bank of Australia recently reiterated a trade recommendation suggesting clients should sell the pound short against the Canadian dollar, targeting a fall in the exchange rate to the 1.4900 level. The bank first entered the trade at 1.6025, with a stop loss of 1.6400.

The-Pound-to-Canadian-Dollar rate was up 0.81% in London Friday, at 1.5962, as the British currency pared some of the week’s loss in the wake of stronger than expected manufacturing data for July.

This is while the Euro-to-Canadian-Dollar rate was 0.28% higher at 1.4606 and the US-Dollar-to-Canadian-Dollar rate was quoted 0.05% lower at 1.2106.

Perhaps the Pound can look forward to further relief if the CAD ship turns direction.