- Canadian dollar the best performing major 'risk on' currency this year
- Weakening economic fundamentals and crude oil outlook set to weigh on loonie
- As US joins global slowdown, all signs point to a stronger US dollar
The Canadian dollar is the best performing major ‘risk on’ currency this year. Against the US dollar, the loonie is down by 4.5% this year. This beats all other major ‘risk on’ currencies including the euro (-5.3%), British pound (-5.9%) and the Australian dollar (-6.9%).
In our last commentary, we argued that the outlook for the Canadian dollar was neutral thanks to rising crude oil prices and accelerating US growth at the time. Given the deep trading relationship between the US and Canada (75% of Canadian exports are destined for the United States), accelerating US growth tends to spill over into the country. While the Canadian dollar has weakened against the US dollar thanks to a relatively weaker growth outlook, the loonie has outperformed its peers.
Going forward, we expect the Canadian dollar to continue weakening against the US dollar. Specifically, we expect (1) slowing growth and inflation, (2) weakness in crude oil prices, and (3) continued US dollar strength to weigh on the Canadian dollar. With regards to NAFTA, an escalation in tensions between the US and Canada could lead to a further deterioration of our bearish outlook.
Inflation set to turn into a headwind, as growth continues to slow
Starting in the second quarter of this year, the Canadian dollar has weakened against its US counterpart. Thanks to decelerating GDP growth, the Bank of Canada has failed to keep up with the US Federal Reserve. While accelerating inflation is raising rate hike expectations (especially after headline inflation accelerated to 3% in July), we argue that the inflation outlook is about to change direction. An overview of recent trends in year-over-year GDP growth and inflation is shown below:
Growth and inflation: deceleration is the trend
Looking at growth, Canadian GDP growth peaked (in rate-of-change terms) in May 2017 thanks to a significant government stimulus program. This is indicated in red in the chart above. Thanks to steepening base effects (mathematically, year-over-year growth becomes more challenging when previous comparables are high), Canadian GDP growth has decelerated since that time. Notably, GDP growth slowed despite a global rebound in 2017 and rising crude oil prices (a key Canadian export). Beyond tough math, drivers for recent Canadian growth are turning into headwinds. Specifically, we expect slowing US growth and falling crude oil prices to weigh on Canadian GDP growth in the future. Our broader take on crude oil is discussed below.
Turning to inflation, rising crude oil prices have resulted in accelerating inflation in all major economies this year. As can be seen above, rising energy prices and a weakening currency pushed headline inflation to 3% in July. Again, the math behind year-over-year inflation figures is a significant factor for the future. In June 2017, year-over-year headline inflation bottomed at 1% and has been accelerating since that time. This is indicated in red in the chart above. Going forward, future inflation figures face increasingly tough comparables. The main driver behind rising inflation, crude oil, is also running out of steam today. As a result, we expect inflation to turn a corner and begin decelerating later this year.
Once both growth and inflation decelerate simultaneously, the Bank of Canada’s hands will be tied by weak economic data. As a result, we expect changing the changing fundamental picture to weigh on the Canadian dollar for the foreseeable future.
Outlook for crude oil, and commodities more broadly, now bearish
Following recent weakness in crude oil prices, we downgraded our outlook on the commodity to bearish. The full thoughts behind our downgrade were discussed in a longer commentary published recently. Our core argument is that weakening supply versus demand dynamics, and peaking US GDP growth will drive the upcoming downturn.
Major turning points in crude oil prices have typically been the result of changes in supply versus demand growth. This is shown below:
Supply versus demand growth: past the flip
As can be seen above, the start of the crude oil bull market coincided with year-over-year world demand accelerating above year-over-year world supply. This makes sense intuitively, as crude oil prices climb when demand exceeds supply. More lately, we have seen the opposite dynamic as supply growth has overtaken demand growth. Unsurprisingly, crude oil has been unable to achieve its highs from earlier this year and is now weakening.
As a commodity currency, weakness in crude oil prices have a direct impact on the currency. Beyond the primary impact, falling commodity prices also tend to weigh on future growth expectations. This year, Canadian manufacturing PMIs (a forward-looking indicator for growth) have been shooting up alongside rising crude oil prices. This is because many aspects of the country’s economy (such as its manufacturing and professional services sectors) are indirectly related to commodities.
As global growth decelerates, US dollar set to shine
The last factor weighing against the loonie is the US dollar. In recent history, the buck has been strengthening thanks to accelerating US growth and inflation. Historically, this has catalyzed rate hikes and has contributed to the relatively strong recent performance of the US dollar. Going forward, we expect both US growth and inflation to begin decelerating, joining the ongoing slowdown in other major parts of the world. As a safe haven currency, global downturns are ideal economic conditions for the US dollar. This is visually illustrated below:
US growth and inflation: upcoming shift
Similar to our outlook for Canadian inflation, steepening base effects and weakness in crude oil is set to weigh on US inflation. Looking at US growth, forward-looking US data (such as ISM sentiment figures, industrial production, etc.) can no longer compensate for increasingly difficult year-over-year comparables. We recently published our broader thoughts on the upcoming US downturn in a recent commentary. Once the US enters a downturn, we expect the US dollar to strengthen accordingly.
Beyond the primary impact of a stronger US dollar, the Canadian dollar will also have to cope with weakness in commodity prices. During downturns, commodity prices tend to trade inversely to the US dollar. Assuming the US dollar continues to strengthen, expect significant weakness across the commodity complex.
Canadian dollar an attractive short opportunity
As the Canadian dollar sell-off has yet to fully play out, the currency is an attractive short opportunity. Between weakening economic fundamentals, a darkening outlook for commodities and ongoing strength in the US dollar, most factors are now weighing against the loonie.
We recommend going long USD/CAD (shorting the Canadian dollar) at the bottom-end of the USD/CAD trading range, which is updated daily on our website.