Canadian Dollar Weakens after Bank of Canada Eschews Rate Hike and Traders Renew NAFTA Focus

-CAD reverses gains, slips after BoC holds rates at 1.5% for September. 

-Clears way for renewed bets against CAD given rising NAFTA risks.

-October hike likely but NAFTA risk sees CAD biased lower for now.

Image © Bank of Canada, Reproduced Under CC Licensing

The Canadian Dollar weakened a touch Wednesday after the Bank of Canada (BoC) left its interest rate unchanged for December as many had expected, leaving investors to focus on mounting risks to North American Free Trade Agreement (NAFTA) and Canada's trade relationship with the US. 

Canada's central bank left its overnight rate unchanged at 1.5% in September, leaving analysts looking firmly to the October meeting for what will be its third interest rate rise in 2018. For weeks now, analysts have been debating the question of whether the BoC will raise rates in September or October, although most favoured the latter for the next move.

The BoC noted that Canadian inflation recently struck the 3% threshold, which is substantially above the central bank's 2% inflation target, but said it expects consumer prices to return back toward 2% in early 2019. It also stuck to its well-worn line that "higher rates will be warranted" in order to ensure inflation does remain anchored close to the target. 

It also forecast that economic growth would likely slow from the 2.9% annualised pace seen in the second quarter to a lesser level in the current quarter due to fluctuations in energy production and exports but said this slowdown should prove temporary. Meanwhile, policymakers will be watching the NAFTA negotiations closely and their impact on the inflation outlook. 

"Discretion is the better part of valour, so a Bank of Canada potentially only days away from getting some clarity on NAFTA was wise enough to defer the next rate move until that news was at hand. Today's decision to leave rates on hold also makes sense in the context of seeing an as-expected Q2 GDP figure and with a 2% core inflation rate not signalling a need to speed up the pace of hikes," says Avery Shenfeld, chief economist at Toronto-headquartered CIBC Capital Markets. "An October rate hike looks highly likely if, as we expect, we have the makings of a NAFTA deal by then."

Pricing in interest rate derivatives markets, which enable investors to protect themselves against changes in interest rates while providing insight into monetary policy, implies an October 24, 2018 cash rate of 1.67%. Set against a current cash rate of 1.5%, which would move to 1.75% after another rate rise, this suggests investors are betting heavily on a rate hike being delivered next month.

Changes in interest rates, or hints of them being in the cards, are only normally made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

Canadian inflation hit 3% back in July, which is substantially ahead of the BoC's 2% target. Economic growth has also surged too, which will add further to inflation pressures during the months ahead, with GDP expanding at an annualised pace of 2.9% during the second quarter.

"Growth and core inflation are still largely where the Bank expected them to be and an October hike is still largely priced in. Markets will be focused on trade comments," says Elsa Lignos, global head of currency strategy at Toronto-headquartered RBC Capital Markets. "Trade tensions were already the “biggest issue on the table” at the July meeting."

The USD/CAD rate was quoted 0.11% higher at 1.3188 following the decision after more than reversing an earlier 0.01% loss, while the Pound-to-Canadian-Dollar rate was 0.91% higher at 1.7091. The Canadian Dollar was a fraction lower against all developed world currencies after the announcement. 

However, the Loonie has wracked up steep losses against many of its developed world counterparts thus far in 2018, as fears over the future of the North American Free Trade Agreement have mounted. Officials from all signatory countries have been attemting to renegotiate NAFTA at the behest of President Donald Trump for more than a year now. 

"Yesterday USD/CAD closed above falling trendline resistance at 1.3109 – this ended the correction via a bullish trend reversal and we are raising our 1-3 month technical target to 1.3300 from 1.2800. Resistance stands at 1.3208, followed by 1.3290 and 1.3386. Support is at 1.3104, followed by 1.3056 and 1.2880," says Lignos. 

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here

NAFTA Talks Roll On after Trump Threat

US and Mexican officials reached a deal in principle last week after freezing Canadian negotiators out of the talks. This saw President Trump present Canada with a choice between signing up to the same terms agreed with Mexico or thrashing out a separate agreement before a Friday 31, August deadline. 

The deadline lapsed without a deal, leading Trump to declare there "is no political neccesity to keep Canada in the new NAFTA deal". Trump also stated that "Canada will be out" if talks to resolve differences over several key issues are unsuccesful. 

Chief among those key issues is the system of subsidies for the dairy sector and tariffs on dairy goods imported from the US. President Trump wants the tariffs lifted and subsidies ended, but Prime Minister Justin Trudeau told reporters Friday that "we are not going to do that". 

"Governor Poloz has said in the past that the announcement of a NAFTA deal alone would not be sufficient to justify tighter policy (or a collapse to weaker policy) but that the BoC would have to weigh movements in CAD and any response by Canadian businesses. They currently estimate trade uncertainty could depress the level of real GDP by ~0.2% by end-2020. Our economists note an agreement could theoretically unwind that," says RBC's Lignos. 

President Trump has the power to withdraw the US from NAFTA, which would effectively mean the end of the trade agreement, and all he need do to set the ball rolling is trigger article 2205 which would set the clock ticking on a six month notice of termination. 

Estimates of what this might mean for the Canadian economy and currency vary widely, although analysts at TD Securities have previously said a US withdrawal would lead to a 20% fall in the value of the Loonie as markets would be forced to mark down their assumptions about longer term growth and interest rates.

Talks between Canadian foreign minister Chrystia Freeland and US trade representative Robert Lightizer are expected to resume Wednesday, although there is uncertainty around how much longer the discussions are likely to go on for. 

"Earlier this week, I announced that my Administration has secured a preliminary deal between the United States and Mexico that modernizes and rebalances trade between our two countries in a way that greatly benefits American manufacturing, agriculture, services, and other sectors. I have also notified the Congress of my intent to sign a trade agreement with Mexico ‑‑ and Canada, if it is willing. The deal I intend to sign will help create more reciprocal trade that grows our economy," says President Trump, in a statement commemorating Labor Day on Monday. 

Advertisement
Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here