Canadian Dollar: "Peak Optimism" Has Now Passed

The Bank of Canada's shift in stance on future interest rate rises means the Canadian Dollar could suffer further decline. 

The Canadian Dollar is likely to struggle over coming months as the Bank of Canada holds its cash rate steady at 1% for an extended period.

At its October policy meeting, the BoC reiterated a positive view of the economy but stopped well short of delivering the 'hawkish message' that further rate rises are necessary that markets had been hoping for.

Furthermore, it is clear that concerns over the higher valuation of the Canadian Dollar - a response to the interest rate rises delivered thus far in 2017 - are influencing policy.

“The repeated references to the CAD weighing on both inflation and exports was enough to send USD/CAD higher and for the CAD to weaken on the crosses,” says Bipan Rai, a macro strategist at CIBC Capital Markets.

Governor Stephen Poloz also flagged a series of risks to their forecasts and lamented that a stronger than expected Canadian Dollar has led them to revise estimates of future inflation downward.

"Although the currency isn’t an explicit policy tool, the Bank of Canada is highlighting that a stronger Canadian Dollar is already weighing on their export outlook. It’s also being flagged as reason why it’s downgraded its inflation forecast - something our research on the topic agrees with," says Nick Exarhos, an economist at CIBC.

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The upshot of Wednesday’s announcement appears to be that the Bank of Canada is now entering the go-slow lane after pushing through two back to back interest rate hikes earlier this summer.

“The Bank of Canada has raised the bar for additional rate hikes despite their claim that the output gap is now closed,” says Richard Kelly, head of global strategy at TD Securities.

The BoC said in its Wednesday statement that, even though "less monetary stimulus" will be need over time, policymakers will be cautious when it comes to making future interest rate adjustments. 

It also suggested rate setters prefer waiting for more post-hike data around growth, wages and inflation to before they vote for further changes in policy.

“Peak optimism on CAD looks behind us with growth moderating and rates reflecting the BoC’s “caution”,” says TD Securities' Kelly. “Risks look asymmetric amid NAFTA uncertainty, dampened exports from previous FX strength, and the BoC’s renewed dis-inflation concerns.”

The Pound-to-Canadian-Dollar rate slipped 0.42% to 1.6910 Thursday as the Loonie drew a renewed bid and Sterling bulls took profits in the wake of Wednesday’s across-the-board gains for the Pound.

The Canadian Dollar had fallen broadly against the G10 basket during noon trading Wednesday but it recovered some lost ground against all of the G10s Thursday with the sole exception being the CAD’s performance against the Australian Dollar.

The Loonie had enjoyed a strong run throughout the third-quarter as traders responded to a back-to-back set of interest rate hikes from the BoC that took the cash rate back to 1%.

“CME data show that non-commercial accounts continue to hold near-record net long positions in CAD futures despite the currency’s near 5% losses since the start of the month,” says Neil Mellor, senior currency strategist at BNY Mellon.

The Canadian Dollar gave back some of the third quarter’s gains once into October as traders second guessed the likely pace of future tightening from the BoC. Nonetheless, positioning remains stretched and vulnerable to an unwind, which would be bad for the Loonie.

“At the moment, the biggest risk for the CAD is positioning with Commodity Trade Advisors still very long in the futures market,” says CIBC’s Rai.

Beyond the immediate positioning risks, the Canadian Dollar’s direction will be dictated largely by domestic economic developments, as they relate to monetary policy.

“Rates markets are reasonably positioned for the BoC, with two more hikes priced i n before the end of 2018,” says Kelly at TD Securities.

The combination of two rate hikes so far in 2017, the implementation of new mortgage rules designed to crimp a growing bubble in the housing market and a minimum wage increase in Ontario could all pose a headwind to the Canadian economy over the coming months.

In addition, uncertainty over the outcome of US efforts to renegotiate the NAFTA free trade agreement could also weigh on the Canadian currency, particularly if talks become more acrimonious in the New Year or if the US withdraws from the accord altogether. 

All of these potential headwinds to the economy have the power to move interest rate expectations, and pricing, backwards, which would have a further negative effect on the Canadian Dollar. 

"We continue to see the C$ weakening to 77 cents-US (USDCAD 1.30) by the early part of 2018," says CIBC's Exarhos.