Canadian Dollar Slumps After Poloz Speech Augurs Fears of Slower Rate Rises

Modified: Tuesday, 13 March 2018 16:29 GMT
Written by: James Skinner

Trade tensions mean the Canadian Dollar is at risk of the Bank of Canada stepping back from raising interest rates in the future.

The Canadian Dollar slumped heavily against its international rivals Tuesday after a speech by Bank of Canada governor Stephen Poloz left markets fearing the central bank could raise interest rates at a slower pace this year than previously thought.

Poloz gave a speech on the modern labour market at Queen’s University in Ontario, where he argued that youth participation in the labour market could be greatly improved, placing a question mark over the idea that the Canadian economy is close to full employment.

Canada’s unemployment rate fell back to a record low of 5.8% in February, according to Statistics Canada data released last week, marking a break with a New Year pattern of softening economic and triggering optimism in the market that the BoC would likely raise interest rates again in May.

“Traditionally, labour force participation rates decline during recessions and rebound during periods of economic growth. But while most other population groups have seen their participation rates recover from the Great Recession, that has yet to occur for young Canadians,” Poloz said Tuesday.

Participation in the labour market and the concept of full employment matter for currency markets because they impact on central bank expectations for wage growth, which is a key driver of inflation and therefore, interest rates.

It is these evolving expectations of changes in interest rates that are, after all, the raison d'être behind most wild swings in currency markets.

“Markets are taking today's speech by Governor Poloz as dovish, but for those who have been listening carefully, there isn't really anything that new here. Deputy Governor Lane had already noted earlier that the Bank still saw at least some elbow room in the labour market, and Poloz has dragged out his earlier argument that the youth participation rate could be improved,” says Avery Shenfeld, chief economist at CIBC Capital Markets.

Poloz’ statement that the labour market has more people to absorb appeared to be taken by the market as having implications for the bank’s inflation outlook. However, it merely continues a theme set out in the Bank of Canada’s interest rate statement last week, as well as one that was communicated by other policymakers earlier.

“Inflation is running close to the 2 per cent target and the Bank’s core measures of inflation have edged up, consistent with an economy operating near capacity. Wage growth has firmed, but remains lower than would be typical in an economy with no labour market slack,” the BoC said in its statement last week.

Nonetheless, the Canadian Dollar fell broadly against the G10 basket of developed world countries in the wake of the Poloz speech.

The USD/CAD rate was 0.69% higher at 1.2931 during late noon trading in London as a result, after having reversed an earlier loss, while the Pound-to-Canadian-Dollar rate was 1.2% higher at 1.8076. The EUR/CAD rate was 1.14% higher at 1.6025.

“While these speeches hint that the BoC might slightly raise potential growth if it argues for a higher participation rate and better productivity, the BoC will still be aiming at a sub-2% growth rate by 2019,” Shenfeld adds.

”What's telling however is that the Governor's choice of topics is in line with our view that he's looking for reasons to take rate hikes slowly. We'll retain our call for only one more quarter point hike this year.”

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The BoC raised interest rates to 1.25% in January, the third increase inside nine months, although recent weeks have seen markets become less confident about it following up with another rate hike in May.

Interest rate derivatives market pricing on January 17, the day when the BoC last raised rates, implied an April 18 cash rate of 1.44%. However, this implied rate had fallen to just 1.34% by 08:00 am on March 13. The implied May 30 cash rate has gone from 1.49% to 1.42%.

In total, those interest rate markets anticipate two more rate hikes from the Bank of Canada before year end, giving a December 05 implied cash rate of 1.76%, which suggests further downside for the Canadian Dollar in the months ahead if Shenfeld is right about the BoC only managing one more hike in 2018.

One key factor in the deterioration of Canadian rate expectations has been rising concerns about the trade environment amidst ongoing negotiations on NAFTA and President Donald Trump’s decision last week to impose new tariffs of 15% and 25% respectively on American imports of aluminium and steel.

Canada has gained an exemption from the tariffs until the North American Free Trade Agreement negotiations have been concluded, although the NAFTA talks themselves are now in their seventh round and remain a long way from producing the required level of progress.

"In a scenario in which NAFTA is actually scrapped (and not simply that a US Notice of Withdrawal is given - the latter does not guarantee the former), we would expect USDCAD to ultimately adjust significantly higher, likely by double digits in percentage terms, as a first order effect," says Ben Randol, an FX strategist at Bank of America Merrill Lynch.

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"A secondary effect - one that markets could price in very quickly - would be a shift by the BoC to a neutral bias."

There are a number of aspects to the existing NAFTA agreement the US President has taken issue with while numerous other analysts have speculated that a US withdrawal from the pact could lead to a double digit devaluation of the Canadian Dollar.

“We remain cautious on the Canadian dollar and see the risk of more underperformance ahead. USDCAD risks appear skewed to the upside,” Randol adds.

“Trade and investment-related uncertainty is building; Canada's Balance of Payment dynamics are getting worse; the BoC accordingly might not be able to track the Federal Reserve.”

In order for the Loonie to stave off further losses against the US Dollar, as well as the broader G10 basket, the BoC will need to keep pace with the Federal Reserve in raising interest rates so as to avoid a widening in short term rate differentials that would damage the Loonie.

However, while markets are becoming almost unanimous in betting the Federal Reserve will raise rates four times in 2018, the BoC has most recently expressed increasing concern about risks to the Canadian economic outlook stemming from a possible escalation of trade tensions.

“After the latest seventh NAFTA round, serious risks still exist as negotiators remain far apart and USD/CAD is trending higher in local US hours,” says Vadim Iaralov, another FX strategist at Bank of America. “Our economists believe that everyone loses in a trade war and our Canadian economist expects NAFTA negotiations to be bumpy and lengthy with significant risks for Canada.”

Trade concerns will matter even more for markets if they lead the BoC to hold off on further rate hikes so traders will be looking to see whether Poloz adds to his previous commentary on the subject this Tuesday.

The Bank of America FX team have been targetting an upward move toward the 1.33 level for USD/CAD over a three-to-six month horizon, ever since November, although their forecast for the exchange rate at the end of June 2018 is 1.2700.

They do not forecast the Pound-to-Canadian-Dollar rate although strategists at Japanese investment bank Nomura have recently recommended to clients that they bet on a sharp rise in this exchange rate over the coming months. Readers can learn more about that idea here.

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