USD/CAD Longs in Trouble as Oil Price Boost Reverses and Bank of Canada set to Cut Rates in 2018

Financial markets have shrugged off the oil price rise as a temporary phenomenom, the Canadian economy is slowing and the BoC has turned dovish. 

Canadian Dollar bulls could be left bitterly disappointed over the coming months if economist forecasts are correct and the recent oil price boost begins to unwind, while the outlook for monetary policy darkens.

Traders had been betting the second-half’s double digit rise in oil prices would work its way into Canadian Dollar exchange rates, particularly that of the USD/CAD price, as year-end approaches.

Following closely on the heels of two back-to-back interest rate hikes from the Bank of Canada, many expected November’s oil price surge to provide the Canadian currency with the tailwind it needed to sustain earlier gains.

“We think the latest leg-up in oil prices - following rising tensions between Saudi A. & Iran - will be reversed and so does not pose a threat to the world economy,” says Paul Ashworth, chief North American economist at Capital Economics, in a recent note. “Investors appear to agree: higher oil prices have not caused inflation expectations to pick up.”

However, five months on from its genesis, broader financial markets are yet to take the latest bull run in crude oil futures prices seriously.

“The real yields of TIPS – which reflect expectations of the future real stance of Fed policy – have barely budged since 21st June despite the surge in oil prices,” says John Higgins, an economist at Capital Economics.

Meanwhile, the outlook for Canadian monetary policy is turning fast, from summer breeze to winter leaves for those who’d been betting on a continuation of the Loonie’s earlier gains.

“The Bank of Canada’s decision to hold interest rates at 1.00% and its less hawkish policy statement indicate it will take a cautious approach, supporting our view that there will be no further rate hikes this year,” says Ashworth.

Canadian policymakers have begun to sound increasingly dovish in their communications, while hitting out at the Loonie for its earlier strength.

“Next year, however, we expect the knock-on effects from a worsening housing downturn to slow the economy and to force the Bank to reverse course,” Ashworth adds.

Like many other developed market countries, Canada has long suffered from the effects of a supply and demand imbalance in its residential property market, which has fed a multi year housing boom now on the verge of turning to bust.

A cocktail of rising interest rates, new rent control measures, taxes on foreign property purchases and regulatory changes to mortgage lending rules has led to a slump in real estate transactions during recent quarters.

Opinions are divided over the extent to which Canada may see a true downturn in its housing market but the Canadian economy has already slowed in recent months, with GDP growth turning negative in August (-0.1%), after having stalled to a halt in July.

The negative wealth effects that could be expected to accompany a fall in property prices could exacerbate the slowdown in the economy.

“We think that GDP growth in Canada will be slower than markets expect next year,” say Ashworth and senior Canadian economist David Madani. “Our forecast is that the Bank of Canada will keep policy rates unchanged until the second half of next year, and will then cut them.”

Capital Economics forecasts that Canada’s cash rate will fall from 1% to 0.50% over the second half of 2018, taking it back to its pre-July level.

The USD/CAD rate was quoted 0.15% higher at 1.2755 during noon trading Tuesday, making the Loonie one of the few G10 currencies to be marked down against the US Dollar.

The Pound-to-Canadian-Dollar rate was quoted 0.18% higher at 1.6740 in late noon trading in London, making the Loonie one fof only three G10 currencies to suffer a loss to Sterling Tuesday. 

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