- NAFTA, crude oil and rate hike expectations have helped the Canadian dollar in recent times
- Looking at the horizon, GDP growth is likely to keep decelerating
- While loonie will ultimately enter bearish trend later this year, current outlook remains neutral
While the outlook for the Canadian dollar looked dire just a few months ago, the currency appears to have recently turned a corner. After looking oversold in late March, the currency managed to strengthen thanks to a rebound in crude oil prices. Two weeks later, the Canadian dollar received more good news as the Trump administration pushed to conclude NAFTA talks at a faster pace. In more recent times, the currency is strengthening once again as traders anticipate more rate hikes. Following the Canadian dollar’s rebound, we have upgraded our medium-term outlook on the currency to neutral accordingly. While the loonie’s comeback has been impressive, the longer-term outlook for the Canadian dollar remains neutral.
Bank of Canada tends to chase trends in growth and inflation
Looking at the BoC’s rate hikes last year, the institution was behind the curve in tightening monetary policy. Similar to other central banks, the Bank of Canada tends to chase growth and inflation once the trend has become fairly clear.
Looking more closely at the data, year-over-year Canadian GDP growth peaked last May (4.5%) and has been decelerating since that time. The impact from the Liberal government’s stimulus program (passed in 2016), came to fruition in 2017 as the government executed its incremental spending plans. Year-over-year growth was also high thanks to weak comparable figures in early 2016 (when growth was just 0.7% - 1.3%). This is shown below:
Both actual growth and future expectations appear to have peaked
While Governor Poloz provided neutral policy guidance in the first half of the year, the Bank of Canada shocked markets by raising rates in July 2017 (after growth had peaked). Since that time, the Bank has raised rates in September 2017 and again in January 2018, bringing the overnight rate to 1.25%.
Looking at the Canadian dollar, the currency has strengthened around recent Bank of Canada interest rate decisions. Unsurprisingly, speculators are keen to bet on the Canadian dollar when the country’s central bank is “normalizing” interest rates.
Future rate hikes to get more challenging
While expectations for future rate hikes have helped the loonie greatly in the last 12 months, monetary policy will be a smaller factor going forward. This is because growth is likely to decelerate significantly.
Following the exhaustion of the government’s fiscal stimulus program, there is no other significant driver for short-term spending. While there is some good news from the country’s crude oil sector (Western Canada Select prices are now trading at a smaller discount relative to WTI), this is unlikely to make up for last year’s significant stimulus. Robust US growth (Canada’s largest trading partner) is another helpful factor. While expectations may be running high, GDP growth is likely to moderate this year. The last issue is that base effects are now working against growth in 2018. Between January 2017 and May 2017, year-over-year GDP growth accelerated from 2% to 4.5%. Comparable figures this year are likely to disappoint as base effects mathematically slow down the rate of growth.
Once the data shows a slowing rate of growth, the Bank of Canada will be forced into halting its normalization process entirely. While speculators are pricing in rates beyond 1.50% over the long-term, they are set to be disappointed.
Crude oil and the US dollar are upcoming headwinds
Additional risks to the Canadian dollar come from the external environment. Thanks to broad global growth in 2017, the US dollar has been weak while commodities (and crude oil in particular) have enjoyed significant gains. The two assets are inversely correlated. As a commodity currency, the Canadian dollar has strengthened alongside higher commodity prices while benefiting from a weak US dollar.
For now, both strength in crude oil and ongoing weakness in the US dollar remain supportive for the loonie. The risk is that these factors may ultimately weigh against the currency later this year. Looking at the US dollar, the currency is set to enter a neutral trend alongside slowing ex-US growth. The buck is also looking ripe for a reversal as the “short dollar” trade has become a consensus idea in the investor community. We covered our longer-term outlook on the US dollar in a recent commentary.
Speculator net positions in crude oil and the US dollar (calculated as the inverse of positions in EUR, JPY, GBP, CAD, AUD and CHF futures and options) is shown below for reference:
The consensus remains firmly short USD and long crude oil
As can be seen above, the long crude oil and short US dollar trades are fairly crowded. While crude oil is likely to keep pushing higher while the dollar remains weak, a reversal of consensus positioning in the future is a significant risk for the Canadian dollar.
The loonie goes neutral
Thanks to the combined impact from NAFTA-related optimism, strength in crude oil prices, and overall weakness in the US dollar, the loonie’s outlook is looking more neutral today. As the economic cycle shows its age, our view is that the currency will re-enter a bearish trend later this year. Ultimately, decelerating GDP growth will force the Bank of Canada’s hand, while the consensus short USD/long crude oil trade is unlikely to last indefinitely.