Sombre Canadian Dollar Heads into BoC Day with Analysts Expecting Little Help from Poloz and his Team

Above: Bank of Canada Governor Stephen Poloz © Bank of Canada

The BoC will raise rates Wednesday, but this won't necessarily translate into Canadian Dollar strength as was the case the last time around. 

The Canadian Dollar rose sharply in 2017 when the Bank of Canada surprised markets by embarking on a programme of interest rate rises, and on Wednesday, January 16 the third installment in the series should be delivered.

However, with the shadow of NAFTA's demise looming large over the meeting, the impact  on CAD this time around might be less muted.

Pricing in ‘overnight index swaps’ markets, which enable investors to protect themselves against changes in interest rates, assigns an 88% probability to the idea the BoC will move on January 17th and is heavily in favour of another rate hike before April is out.

Any failure to deliver on the expectation for an interest rate rises will spark volatility in bond and currency markets as an overwhelming majority of analysts, economists and traders have primed markets for the event.

Why then is there scepticism in the Canadian Dollar's ability to advance in an environment of rising interest rates?

The threat of a US withdrawal from the North American Free Trade Agreement is growing by the day and there are a litany of other economic and political risks that could also incentivise the BoC to wait-and-see for a bit longer. (Readers can learn more about what a US withdrawal from NAFTA might mean for the Loonie here.)

“The Canadian Dollar lost a few fans this week when markets were shocked, shocked, by a news report that the US tipped Canada that it will put us on notice of its intent to withdraw from NAFTA,” writes Avery Shenfeld, chief economist at CIBC Capital Markets.

“The White House followed up that report with a statement saying that the President’s view on NAFTA had not changed. Exactly. It’s the worst trade deal ever, remember?”

It would be bad for the Canadian Dollar if the BoC does decide to wait and see, or even if it hints that it might not be able to live up to market expectations, such is the extent to which traders have come to expect another two back-to-back interest rate rises like the ones spanning July and September 2017.

CIBC Capital Markets therefore forecast that the BoC will not dissapoint. Rates will go up, according to their latest economics briefing, although this doesn’t mean Canadian Dollar bulls will be vindicated for bets that have driven the Loonie up by 3.5% against the Dollar in the last month.

Above: USD/CAD rate shown at daily intervals.

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“The Bank chose to put a very positive spin on its Business Outlook Survey, and give particular emphasis to results that showed the economy is running at full capacity. It’s not going to be scared off yet by some Donald Trump bluster. But perhaps those going long the Canadian dollar on this interest rate story should be,” writes Shenfeld.

Why CAD Won't Oblige

Even if the BoC does deliver the goods this Wednesday there are grounds for scepticism over whether the Canadian Dollar can continue its recent star performance.

For a start, the country has a yawning current account deficit with the rest of the world, which means Canada spends more money overseas than the rest of the world spends in Canada.

This creates a natural source of downside pressure on the Loonie. One that could get worse if the Bank of Canada were to raise rates Wednesday but signal a slower pace of hikes to come over the rest of the year, as foreign capital flows might might be drawn away by the allure of rising interest rates elsewhere.

Secondly, the ongoing dispute over NAFTA could see foreign direct investment and Canadian business investment slow, as companies add manufacturing capacity on the US side of the border instead of on the Canadian side.

“Both will have the invisible hand of markets finding a weaker equilibrium for the loonie,” says CIBC’s Shenfeld.

Shenfeld forecasts that the USD/CAD rate could rise back to 1.30, from its current 1.2424 level, over the coming months as a result of uncertainty over the future of NAFTA and Canadian monetary policy. He recommends CIBC clients protect themselves against forthcoming volatility in exchange rates.

Assuming the Pound-to-Dollar rate holds steady around the 1.3700 level, this would push the Pound-to-Canadian-Dollar rate back above 1.8200, representing a near 7% gain for buyers of the Loonie.

Above: Pound-to-Canadian-Dollar rate shown at daily intervals.

“Our call is that the BoC will follow through with a hike at the January meeting. If delivered, USDCAD may sell off by perhaps temporarily given the event is about 80% priced. If BoC opts to wait given NAFTA risks and remaining uncertainty regarding the data, we think USDCAD could potentially rally by around 2% in a straight line” say Ben Randol and Adarsh Sinha, both fx strategists at Bank of America Merrill Lynch.

The USD/CAD rate fell sharply over the course of December, from 1.2900 at the beginning of the month, to 1.2350 in the first week of January.

“Two exceptionally strong Canadian employment reports were responsible for the bulk of the USDCAD repricing attributable to CAD-specific factors. The broader context has been characterized by a generalized repricing of global central banks alongside a melt up in global oil prices and a sharp rebound in Western Canada Select crude, specifically,” say Randol and Sinha.

However, they too see risks stacking up against a diminishing pile of potential rewards for Canadian Dollar bulls during the months ahead. Front and centre is the renegotiation of NAFTA, which President Donald Trump described as the “worst trade deal in history” when campaigning for the White House.

Fears are that, with the midterm elections this November now fast approaching, President Trump might feel incentivised to tear up the agreement, or at least make a spectacle of putting Canada and Mexico on notice, in order to shore up support for the Republican Party within the rust-belt states that have done badly from the NAFTA deal.

In addition, much of the argument for another rate hike by the BoC so soon, rests on the merits of two surprisingly strong employment reports.

There is no doubt about the bullish signal coming from the reports however, an unknown quantity of the the labour market strength may simply have been the result of a festive and entirely seasonal dividend.

“The BoC is now priced to hike by more than the Fed in 2018, which we think is wrong. Thus, although we see the recent USDCAD repricing as supported by fundamentals, we doubt the recent trend lower is sustainable except under a scenario of major oil price rerating,” say Randol and Sinha.

Beware the Surprise

This could mean that, despite the heavy odds in favour of a rate hike, the current Canadian Dollar narrative is just fool’s gold for speculators. Only time will tell.

“Unlike some central banks, the BoC seems to not mind surprising markets. Looking at rate decisions over the last 8 years, there are multiple occasions when the BoC defied expectations,” says Elsa Lignos, global head of FX strategy at RBC Capital Markets.

The Bank of Canada took markets by surprise back in September when it hiked the cash rate for a second time just as many months, taking it up to 1%. As noted by RBC’s Lignos, it might be apt to surprise again Wednesday.

Lignos and the RBC team predict, like many others, that the BoC will go ahead and raise the cash rate up to 1.25% this Wednesday. Although they also say the Canadian Dollar might struggle to draw another boost from this.

“We will keep a forecast above 1.30 for end-Q1 to signal the heightened risk that Trump announces an intention to withdraw from NAFTA by the end of the quarter. But we look for CAD to recover by year end, with an unchanged forecast for end-Q4 (1.24),” Lignos writes, in a recent briefing.

RBC, CIBC and Bank of Amerrica are all broadly on the same page when it comes to USDCAD and its likely performance over the coming months. All say the BoC will take the plunge this Wednesday and all flag downward pressures ahead for the Loonie.

The Bank of Canada will announce its latest interest rate decision at 15:00 pm London time on Wednesday. Readers can learn more about what other forecasters say 2018 has in store for the Canadian Dollar here; Compilation of Major Bank Forecasts, Currency Views for 2018. 

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