Canadian Dollar: Federal Reserve to Challenge Loonie ahead of Latest NAFTA Deadline

Image © Bank of Canada

- CAD faces headwinds from Federal Reserve and NAFTA deadline.

- Fed dots see CAD-negative interest rate dynamics under spotlight.

- NAFTA deadline looms but Deutsche Bank say elusive deal no panacea. 

The Canadian Dollar is facing fresh losses according to multiple analysts, who say economic data and the Federal Reserve will both pose as headwinds to the currency this week while a deal to save the North American Free Trade Agreement (NAFTA) will be no panacea for the Loonie. 

Toronto-headquartered Scotiabank says Wednesday's interest rate decision and economic projections from the Federal Reserve will place the widening gap between Canadian and U.S. interest rates under the spotlight ahead of Friday's GDP data, at a time when the Loonie is already vulnerable to fresh losses.

"All eyes are on Wednesday’s Fed and the outlook for relative central bank policy remains bearish as yield spreads widen in a CAD-negative manner," says Shaun Osborne, chief currency strategist at Scotiabank. "CAD remains vulnerable as it continues to trade well above levels implied by our Fair Value estimate (1.3248) using yield spreads and Canada’s terms of trade index. Measures of sentiment and positioning are bearish."

The Fed is widely expected to raise the Federal Funds rate range from 1.75% to 2%, to between 2% and 2.25%, on Wednesday and by another 25 basis points in December. This well priced by the market so traders will be looking to the so-called dot-plot for clues as to how high interest rates may go in 2019 before they place bets on the U.S. Dollar. 

Fed policymakers have nudged their median projection for U.S. interest rates at the end of 2020 higher throughout the last year, taking it from 2.9% back in September 2017 to 3.4% by June 2018. If this number moves higher again on Wednesday then it could boost the U.S. Dollar, including the USD/CAD rate. 

The Bank of Canada (BoC) on the other hand, is expected to raise its interest rate only one more time in 2018 while the outlook for 2019 monetary policy is still clouded by uncertainty over the NAFTA negotiations. 

"We think the move to 1.29 reflects some repricing of NAFTA risks but argue a gap exists between a law and a handshake," says Mark McCormick, North American head of FX strategy at Toronto-headquartered TD Securities. "We continue to like the buying opportunities in USDCAD ahead of the 200 day-moving-average near 1.287."

TD Securities' and Scotiabank's calls come after three weeks of solid gains for the Canadian currency, brought about largely by hopes that a deal to save NAFTA will soon be reached. 

Friday is the latest deadline for an agreement to be struck and, although some say negotiators actually have a little longer, the Canadian Dollar may still react badly if the date passes without event. 

"The major talking point is whether the parties can make a handshake deal that pulls Canada into the bi-lateral agreement already snagged by the US and Mexico. Once again, while markets cling to a so-called NAFTA resolution, we don't think a handshake does much besides kicking the can down the road," says McCormick. 

Officials from both sides of the U.S.-Canada border are thought to be aiming for an agreement before Friday because after that point U.S. legislators will not have the necessary 60 days to scrutinise the deal ahead of its signing, which is required by law, before incoming Mexican president Andres Manuel Obrador Lopez takes office in December. 

Most analysts expect the Bank of Canada would continue raising its interest rate if a NAFTA deal is reached but that it could stop hiking, or maybe even cut rates, if President Donald Trump withdraws the U.S. from the pact. TD Securities 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 economic growth and interest rates.

"While a NAFTA conclusion may unlock some pent-up business investment, we do not believe this would entirely lift the storm-clouds for CAD, and would only result in a temporary boost towards 1.28 without much room for further follow-through," says Alan Ruskin, global head of currency strategy at Deutsche Bank, in a recent note to clients. 

Ruskin and the Deutsche Bank team say a NAFTA deal could see the Bank of Canada add as much as 40 basis points, or 0.4%, to its forecasts for Canadian economic growth over coming years but this is unlikely to lead to anything more than one additional interest rate rise in 2019. 

"Versus the Fed, which we see raising rates six times to 3.4% Fed effective from 1.92% currently, this still means a widening of the front-end rate differential from 50 bps currently to at least 65 bps, and as much as 90 bps (in the event of BoC holding at 2.50% instead of moving to 2.75%) by end-19. Needless to say this would be negative for CAD, which is already slightly expensive versus terminal rate spread," Ruskin writes.

Just like TD Securities, Ruskin and the Deutsche Bank team are sellers of the Canadian Dollar and buyers of USD/CAD in the options market. They anticipate the Canadian Dollar will weaken again before year-end in a move that could push USD/CAD back up to 1.3250. 

The USD/CAD rate was quoted 0.05% lower at 1.2942 during noon trading Tuesday but is up 3% for 2018, while the Pound-to-Canadian-Dollar rate was 0.25% higher at 1.7027 and is up 0.5% this year. The Loonie was also higher against most of the rest of the G10 basket.

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