The Canadian Dollar is Holding NAFTA-induced Gains but Analysts are Urging Caution

-CAD remains on front foot as NAFTA optimism dominates market.

-But analysts are sceptical of recent headlines and wary of the CAD.

-CAD outlook remains fraught with risk, deal need by month-end.

© Pavel Ignatov, Adobe Stock

The Canadian Dollar remained on the front foot Wednesday after statements from President Donald Trump and other officials gave markets fresh hope a deal to preserve the North American Free Trade Agreement can be reached, but analysts are sceptical of recent headlines and reluctant to back the Loonie.  

Sceptics say the talks are still ongoing, the timing of any agreement is not yet known and that the NAFTA saga will damage Canada's trade and economy even if the pact is eventually saved. In other words, the outlook for the Loonie still remains fraught with risk and Wednesday's move may have been overdone.

"USD/CAD fell around 80pts (low 1.3042) around the North American close as President Trump said the NAFTA talks were “going well” and reports said Canada is “ready to allow the US limited access to Canadian dairy markets.” There is no detail beyond the headline and CAD’s rally looks a little overdone," says Adam Cole, chief currency strategist at Toronto-headquartered RBC Capital Markets. "1.3045 serves as support and resistance is at 1.3132."

Officials from all three NAFTA signatories have spent more than a year attempting to agree terms more palatable to the US administration after President Trump made renegotiating the deal an electoral priority.

The US and Mexico reached a bilateral agreement in late August and Trump gave Canada only limited time to sign up to that deal or negotiate something different directly with the US. 

US-Canada talks are ongoing and negotiators are under pressure to reach agreement before the end of September. Beyond this point the White House would need to begin a separate legislative process to progress the Canada deal, which could be made difficult by November midterm elections that could hand the House of Representatives to the opposition Democratic Party. 

“This is really a moment when speaking and meeting face to face with the Prime Minister is really essential,” says Chrystia Freeland, Canadian foreign minister, to reporters in Washington Tuesday.

The US wants to abandon the Chapter 19 dispute resolution mechanism in the existing NAFTA agreement, which empowers an arbitration panel to settle disputes with binding rulings.

It has also demanded, among other things, that Canada lift tarrifs on imports of US dairy goods and taken aim at Canadian government subsidies of the politially-powerful dairy industry. 

Canadian Prime Minister Justin Trudeau said at the end of August "we're not going to do that", sparking a rout in Canadian Dollar exchange rates. 

However, the Globe and Mail reported Tuesday that Canadian officials may now be softening their stance on the dairy sector. Freeland left Washington that night and was reported to be heading for a meeting with PM Trudeau. 

"The clock is ticking. An agreement has to be reached by the end of September," says Esther Reichelt, an analyst at Commerzbank. "The uncertainty as to whether Trump would end NAFTA and Congress and Mexico would indeed block a purely bilateral agreement between the US and Mexico is likely to justify a considerable CAD risk premium though."

President Trump has the power to withdraw the US from NAFTA, which would effectively end the trade agreement, by triggering article 2205 which would set the clock ticking on a six month notice of termination.

Toronto-headquartered TD Securities has 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.

As things stand, currency markets are betting heavily the Bank of Canada, which has raised rates twice this year, will pull the trigger on another interest rate rise in October. But failure to agree a deal in September could see this conviction wane, placing the Canadian Dollar under fresh downward pressure. 

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.

"We’re in no better place than other observers to know how this story will end, but two things are certain: it won’t mean “free trade”, and it won’t be the end to Canada’s challenges on the export front," says Avery Shenfeld, chief economist at Toronto-headquartered CIBC Capital Markets. "Even if reaching a NAFTA deal provides shelter from auto tariffs, producers of softwood lumber, certain paper products, steel, and aluminum don’t need to be reminded that we don’t have “free trade” at this point."

The USD/CAD rate was quoted 0.04% lower at 1.3056 during noon trading Wednesday and is down 0.89% for the week-to-date, while the Pound-to-Canadian-Dollar ratewas 0.10% lower at 1.6986 and is down 0.16% this week.

The Canadian Dollar was up a fraction against half the G10 basket Wednesday but has advanced against most rivals in the last week. However, it is down against almost all of its rivals for the year-to-date, which is a symptom of investor unease over the NAFTA negotiations.

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