Canadian Dollar Under-performs Peers as Doubts Over Bank of Canada Interest Rate Outlook Grow

-CAD slips Thursday even as oil prices and other risk assets rise.

-Doubts grow over NAFTA, Bank of Canada monetary policy outlook.

-USD/CAD to rise say Credit Suisse, EUR/CAD higher say TD Securities.

© kasto, Adobe Stock

The Canadian Dollar weakened broadly Thursday despite signs of a tentative recovery in oil prices, making it one of only two so called G10 currencies to cede ground to the US Dollar, and the latest analyst commentary on the Loonie suggests this underperformance can continue for a while yet.

Thursday's price action is noteworthy as it comes amid signs of an upturn in global growth and renewed risk appetite in financial markets, which have seen the US Dollar weaken broadly and "risk currencies" like the New Zealand Dollar perform well.

The Australian Dollar has also seen a positive week, thanks to stronger than expected GDP numbers and an easing of fears over the stability of the Eurozone and a possible "trade war" between the US, Europe and China. Even the Euro has emerged resurgent from the depths of a months-long slump that appeared to end earlier this week. 

However, the Canadian Dollar has lagged its peers in staging a riposte against the Dollar, with the USD/CAD rate unchanged over a one week horizon and up by 0.5% in the last month. The exchange rate has risen 2.9% for 2018. 

Above: USD/CAD rate shown at daily intervals.

The Loonie's performance against other currencies, or on the so called "cross rates", has been even worse with the Canadian currency ceding ground to almost all of the G10 during the last week. And this looks set to continue too. 

"Yesterday, we noted that we may rotate our NZDCAD long into EURCAD as escalating trade wars and an already priced BoC tightening path suggests that CAD could still have more to lose than to gain," says Mazen Issa, an FX strategist at Toronto-based TD Securities. "Technically the pair looks very constructive following a break of the 200-day and also flirting with a re-entry into an uptrend channel established from the 2017 lows.

Issa and the TD Securities team have been betting against the Canadian Dollar in recent weeks, entering a "long" NZD/CAD position at 0.8970 and targeting a move up to 0.93. They are now eyeing an anticipated downward rebound in the EUR/CAD rate, from 1.5470, as a potential opportunity to buy.

Their rationale for betting against the currency is that markets are being too optimistic about the number of times the Bank of Canada (BoC) can raise interest rates during the months ahead, given increasing levels of uncertainty about the future of the North American Free Trade Agreement. 

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

Markets are looking for the BoC to raise its interest rate by 25 basis points to 1.5% on July 11 and by a further 25 basis points before the end of 2018. Pricing in overnight index swaps market implies an 80% probability of a July hike, a 76% probability of another increase in December and a 40% probability the BoC will pull the trigger again in March 2019. 

Those same markets imply almost exactly the same chances of exactly the same number of interest rate rises from the Federal Reserve in the US. Although the BoC has traditionally lagged the Federal Reserve in raising its rates. 

"We remain of the view that there is scope for divergence to emerge here, which casts a bearish structural outlook on the loonie. This would, however, require the BoC to openly start factoring in higher risks to growth from trade uncertainty," says Alvise Marino, an FX strategist at Credit Suisse.  

Both Marino and Issa at TD Securities are sceptical of whether the Bank of Canada will be able to live up to current market expectations. 

"A more dovish turn by the BoC could in our view open the path to a significant break above 1.30 in USDCAD in the nearterm. A test of the March highs at 1.3125 would be the first stop, with a more substantial test at 1.32," Marino adds.

Above: USD/CAD rate shown at weekly intervals.

Although the Canadian economy has shown signs it is recovering from a seasonal slowdown at the start of the year and inflation is already above the central bank's target, three rate-rises in nine months may be too much in light of risks to the future of the NAFTA agreement. 

But if the BoC fails to deliver and markets then the Canadian Dollar would suffer because it is the promise of higher rates that has warded off steeper trade-related losses this year. And risks on the trade front have been building of late. 

"USD/CAD has not participated in the most recent pullback in the USD, despite a more hawkish BoC last week," says Richard Franulovich, head of FX strategy at Westpac. "With NAFTA breakup risk on the rise [and the] US administration signaling a preference to split negotiations and pursue separate deals with Canada and Mexico, it's hard to see USD/CAD much below 1.28 near term until NAFTA uncertainty lifts."

White House economic adviser Larry Kudlow told Fox & Friends Tuesday that President Donald Trump is contemplating separate negotiations with Canada and Mexico, rather than the current format where the US sits with both other parties. Kudlow's comments came hard on the heels of more telling remarks by President Trump himself on Friday.

"I wouldn't mind seeing a NAFTA where you go by a different name, where you make a separate deal with Canada and a separate deal with Mexico. Because you're talking about a very different two countries," President Trump told reporters last week, hinting at replacing the current NAFTA deal with two separate bilateral agreements.

The NAFTA stakes are high for the Loonie because some analysts have estimated the currency could fall as much as 20% if the White House goes for the nuclear option and announces a US withdrawal from the agreement. This would set the clock ticking on a six month termination period.

“Market rate hike expectations in Canada would fall but not fully price out tightening and price in termination,” writes Brittany Baumann, another FX strategist at TD Securities, in a January note. “Wider rate spreads would drive CAD to weaken by 8-10% based on the elasticity in our fair value model.”

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

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