Canadian dollar pain to continue, but some hope is on the horizon

BY DEB SHAW | 

  • Bank of Canada surprises again by dampening the rate hike outlook
  • Long Canadian dollar is a crowded trade, and dangerous for many reasons
  • While short-term looks bleak, rising crude oil prices provide some hope for a future rebound

The Bank of Canada has been full of surprises this year. In our previous take on the BoC’s last interest rate decision in September, we remarked that Governor Poloz likes to keep markets on their toes by incorporating an element of surprise in his announcements. Judging by the outsized reaction in USD/CAD and EUR/CAD last night, markets were clearly not expecting the BoC to dampen expectations for future rate hikes.

After confidently embarking on a path to ‘normalize’ interest rates over the summer, the Bank has now altered its course. Looking at bond markets, rate hike expectations for December 2017 have dropped below 30%. Far from being on a hiking path, the Bank looks set to switch into neutral for the time being. Given that December rate hike odds in the US are approaching 100%, USD/CAD is more likely to keep weakening in the short-term on rising interest rate differentials. Even 30% odds sound high for a December rate hike given Poloz’s tone yesterday, and this has yet to be priced into the currency.

 

Long Canadian dollar a dangerous place to be

We have repeatedly warned that the long Canadian dollar trade, despite being a favorite amongst speculators, was fraught with risks.

GDP growth numbers are falling in rate-of-change terms after peaking in the summer, a topic we covered in our broader outlook for Canadian growth. After peaking at 4.6% year-over-year growth in May 2017, the latest growth figures have slowed to 3.8% in July 2017 and remain on a decelerating trend. Looking at sentiment, long Canadian dollar positions have been elevated relative to recent history in futures markets. With 77,368 futures and options contracts long (as of October 17, 2017), long Canadian dollar positions are two and a half standard deviations above their 3-year trailing average. Unsurprisingly, the BoC’s move to lower rate hike expectations yesterday caused a stampede for the exits. An overview of recent Canadian dollar futures and options positions is illustrated below:

Futures & options speculators love their loonies

10-26-2017 CAD CFTC
Source: CFTC

 

Lastly, Canada is also now prone to political uncertainty thanks to ongoing NAFTA negotiations. While the US-Canada free trade agreement makes a lot of sense for both sides (given the complementary nature of the two economies), the incremental benefit of including Mexico is unclear. In our broader take on the NAFTA negotiations, we argued that the long-term impact is likely to be neutral for Canada, despite ongoing tensions in the short-term. As the likelihood of NAFTA getting scrapped entirely becomes more and more likely, the Canadian dollar is likely to stay weak in the short-term.

Domestic politics, via the federal government’s fiscal stimulus program, have helped the currency strengthen in 2017. Yet for the remainder of the year, international politics are more likely to weigh on the Canadian dollar.

 

Some hope on the horizon

While the short-term outlook for the Canadian dollar looks bleak when looking at growth, monetary policy, sentiment or politics, there is some good news on the horizon. As one of the world’s largest crude oil exporters, the Canadian dollar tends to rise and fall alongside crude oil prices. In recent weeks, the Canadian dollar has diverged sharply below its historical relationship with crude oil. Given our view that crude prices are more likely to keep rising in 2017 thanks to limited supply, the Canadian dollar will get some support from strong crude oil in the near future. Despite the fact that the Canadian dollar and crude oil prices don’t always trade in tandem, they tend to be mean-reverting over longer time horizons for a good reason. This is illustrated below.

 

CAD falls sharply below WTI crude, but expect this to change in later months

10-26-2017 CAD Crude
Note: USD/CAD inversed; crude oil shown as black line
Topics: Canadian dollar

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