After five years of rapid appreciation, the Canadian dollar seems to be losing its charm. In the first quarter of 2008, despite the rise of crude oil to more than 110 U.S. dollars per barrel, the loonie depreciated dramatically against the world’s most heavily traded currencies on evidence that the Canadian economy was beginning to slow and the Bank of Canada would be forced to cut interest rates faster than traders had expected. The Canadian dollar underperformed particularly against lower yielding currencies like the Swiss franc and the Japanese yen but traded in a relatively tight range against the U.S. dollar. For instance, since the beginning of 2008, the Canadian dollar lost more than 17 percent against the Swiss franc, 15 percent against the Japanese yen and nearly 11 percent against the euro. In fact, the U.S. credit market turmoil, which was triggered by a wave of payment defaults in the U.S. subprime sector, forced many investors to cut holdings of higher yielding currencies like the Canadian dollar. Yet, the current market environment of manic volatility does not explain the full extent of losses suffered by the loonie in recent months. For instance, even the U.S. dollar, which has been free falling against other currencies since it became clear that problems in the U.S. housing market were spreading across other sectors in the world’s largest economy, ended up the first quarter almost 3 percent stronger than the Canadian dollar. So what went wrong for the Canadian economy and what is its outlook for 2008?
[B]Canada is Feeling the Pain from a U.S. Economic Slowdown[/B]
From 2002 to 2007, the Canadian economy expanded strongly, growing by an average of 2.6 percent per year, measured in terms of real growth rate. Strong commodity prices generated a substantial boost for the Canadian economy and the resulting rise in real incomes provided the necessary support for domestic demand, private consumption, construction spending and investment in machinery and equipment. Moreover, employment grew consistently over the past few years, bringing the jobless rate to a 33 year low, according to Statistics Canada. Yet, while domestic spending has remained robust, Canada is now feeling the pain from a U.S. economic slowdown. For instance, Canada’s exports weakened significantly in the last 6 months reflecting a clear slowdown in the U.S. economy and the impact of the past appreciation of the Canadian dollar. In fact, both of these events combined with increasing competition from emerging markets like China, India and Brazil are having a direct impact on several Canadian industries including lumber, building materials and the automotive industry. Furthermore, the ongoing deterioration in the U.S. housing market is contributing to further tightening in credit conditions around the globe and the Canadian economy is likely to experience a deeper and more prolonged slowdown than had been projected by Canada’s financial and monetary authorities. The Bank of Canada now projects that economic growth in 2008 will be weaker than was expected, averaging 1 per cent in the first half of the year and 2 per cent in the second half. On an average annual basis, the economy is expected to expand by 1.8 per cent in 2008 and by 2.8 per cent in 2009. However, not everyone shares the same bearish view in the Canadian Economy. According to the Conference Board of Canada, strong consumer spending could help drive growth of 2.2 per cent this year, offsetting weak exports into the United States. The Ottawa based group believes that steady consumer confidence and easing interest rates should help keep Canadians spending.
[B]Bank of Canada says Risks for Inflation had clearly Shifted to the Downside[/B]
Although the Bank of Canada aims to keep inflation at the 2 per cent target, the recent turbulence in global financial markets have been the main concern for the Bank of Canada and not inflationary pressures. On April 4, the Bank of Canada announced that it was lowering its target for the overnight rate by 50 basis points to 3 1/2 per cent. The BoC judged that the balance of risks for inflation had clearly shifted to the downside and further monetary stimulus would be required in the near term to keep aggregate supply and demand in balance. In the opinion of the governors of Canada’s central bank, the deterioration in economic and financial conditions in the United States can be expected to have significant spillover effects on the global economy, and important downside risks to Canada’s economic outlook were identified. Moreover, since August 2007 the Bank of Canada, included in a group of the world’s most powerful central banks, has provided liquidity into the financial system to minimize the effects of the U.S. credit crunch. The BoC has been effective in keeping the overnight interest rate close to target but even though Canada’s banking system is currently better than it was in December, credit spreads are still very high and the central bank has indicated that it plans to expand the list of collateral that it will accept on its Standing Liquidity Facility.
[B]Since Crude Oil is trading above $110 why the CAD has been falling?[/B]
Commodities like oil, natural gas and gold account for nearly half of Canadian exports. However, the economic relation between the USD/CAD and crude oil has deteriorated considerably over the past few months (chart is below). More specifically, the 3 month rolling correlation between the USD/CAD and the nearby NYMEX WTI Crude oil futures contract is now very close to zero. In our opinion, the considerable drop on the correlation can be explained by the 40 percent appreciation of the Canadian dollar against the U.S. dollar over the past five years. In fact, until very recently, strong commodity prices had been generating a substantial boost to incomes in Canada. However, the change in terms of trade (price of exports divided by the price of imports) has been so drastic that many Canadian exporters are no longer competitive, particularly in the manufacturing sector. For instance, after several months of job gains, Canada’s unemployment rate unexpectedly rose to 6 percent in March from 5.8 percent in February according to Statistics Canada. Furthermore, according to the same report, the struggling manufacturing sector lost 9,400 jobs in March and a massive 113,300 jobs over the last 12 months.
[B]Q2 2008 Outlook for the Canadian Economy[/B]
Looking ahead, the biggest challenge facing the Canadian economy is the remarkable slowdown in the U.S. economy which is expected to have considerable spillover effects on the global economy. In addition, the Bank of Canada will continue to monitor price pressures but given that current Core and CPI inflation have been consistent with its target for sustainable growth, we believe the central bank is likely to ease its monetary policy and focus on growth. According to interest rate swaps for deposits denominated in Canadian dollars, the market has already priced in one additional rate cut by the Bank of Canada in 2008. While the 3 month swap rate stands at 3.61 percent, the 1 year rate is being offered at 3.36 percent, a negative term structure spread of approximately 25 basis points. Moreover, the pace of the interest rate cuts is likely to be dictated by the tightening in credit conditions linked to the collapse of the U.S. subprime-mortgage market. But what does lower interest rates mean for the Canadian dollar? In general, lower interest rates make holding the Canadian dollar less attractive to foreign investors, and the lower level of demand could place downward pressure on the value of the loonie. It is also true that a reduction in interest rates should help to stimulate the Canadian economy by making borrowing more attractive. However, the credit market is so tight that this scenario is very unlikely. In sum, the Canadian dollar is expected to continue to depreciate in 2008.
<strong style=""><u>USD/CAD Technical Outlook</em>
A major multi-year low could be in place at .9055. The decline from the 2002 high at 1.6189 is in 7 waves and counts perfectly as a double zigzag, labeled W-X-Y. The reason that we propose the major low scenario is that the strength and form of the rally from .9055 is indicative of a major turn. The 13 day rate of change from .9055 to 1.0248 was the highest that it had been in years. Momentum extremes such as this ‘announce’ major trend shifts when the move occurs from a significant high or low.
