USD/CAD Third Quarter FX Outlook

The Canadian Dollar has shown truly impressive strength in the first half of the year, reaching 30 year highs against its US dollar and outperforming all major currencies on a year-to-date basis.

The Loonie made a definitive turn higher in late March on speculation that the Bank of Canada would raise interest rates through the medium term. Indeed, domestic Core CPI jumped well-above the central bank?s target of 2.0 percent and has led to the BoC?s decision to take rates to 4.50 percent through July. Given the extent of the CAD?s rally, however, many now wonder whether the currency has fully priced in improving interest rate differentials and is now due for a turn. Such an outlook depends on one key question- will the Bank of Canada raise rates to 5.00 percent?
[B]Interest Rates Hold the Future[/B]
Interest rate futures forecast that the 3-month Canadian London Interbank Offered Rate (LIBOR) will settle at approximately 4.95 percent in December. The LIBOR has in the past ten years averaged 13 basis points above the Bank of Canada?s Overnight Rate, which implies that traders expect a definite 25 basis point rate hike through year-end and a 30 percent likelihood of rates at 5.00. Yet such uncertainty is what could potentially be the Loonie?s undoing. The Bank of Canada raised its overnight lending rate to 4.50 in July, citing above-target inflation as the main risk to the domestic economy. Through the attached communiqué, the BoC said that it expected price pressures to fall to target levels through the end of 2008. This outlook signaled that “some modest further increases in the overnight rate may be required to bring inflation back to target over the medium term.” The key word “modest” quelled speculation that the bank would aggressively tighten in the coming months. Indeed, it is questionable whether market expectations of a potential 50 basis points hike by the end of the year will prove feasible. Such a question almost entirely hinges on domestic price pressures through the medium term.
[B]Inflation Inextricably Linked to the Domestic Currency[/B]
Inflation has failed to moderate through recent months, with the Bank of Canada forecasting that the Core measure will remain above the key 2.0 percent mark until 2009. In fact, current forecasts show inflation peaking at 3.0 through year-end 2007. Such statements would certainly imply that the bank is not done raising rates, but the central authority likewise expects that the incredibly strong Canadian dollar will place downward pressure on the CPI measure. The Canadian economy remains one of the most trade-dependent of the world, with total exports and imports at three quarters of annual Gross Domestic Product in 2006. Bilateral flows with the US account for the lion?s share of this commerce, as 80 percent of exports and nearly 60 percent of imports involve its North American neighbor. This means that the USDCAD at multi-decade lows may have quite the pronounced impact on the country?s net balance of trade going forward.
[B]Export Industries[/B]
Given a strong currency, the Canadian consumer may look to purchase more in foreign goods, while domestic production becomes much less competitive in the global market. This double-whammy on the Canadian trade surplus could have lasting effects on the overall economy. As a direct contributor to GDP* growth, the immediate effect is to lower BoC?s long-term forecasts on overall expansion. Mid-year trade numbers have not yet shown the effects of the strong C$, however, with the economy?s large export sectors well hedged against Loonie strength for quite some time. Large multinationals have been actively hedging adverse currency risk through the forwards and options markets. This implies that the true effects of the recent strength in the Loonie will not be seen for quite some time. For example, Canada?s largest aerospace manufacturer Bombardier hedges approximately 60-80 percent of all its currency needs on a 12-18 month time horizon. In low profit-margin industries, this can mean the difference between remaining afloat and shuttering doors. Indeed, there have been several high-profile plant closings in domestic lumber industries that cite the Loonie as the primary factor of poor performance. Given that this weakness occurred within the context of strong commodity prices, it serves to note that the Canadian economy is still quite vulnerable to the overall performance of raw materials.
[B]Oil and Metals Prices Still Matter Despite Evidence to the Contrary[/B]
The market focus on the future of Canadian interest rates has left a key pillar of Loonie strength relatively ignored: the price of oil and other key commodities continue to have an impact on the USDCAD exchange rate. In fact, the correlation between fluctuations in the price of Crude Oil and the USDCAD has remained relatively stable through year-to-date. At 0.30, such a correlation hardly tells the entire story of Loonie strength. Yet it is virtually undeniable that oil?s rally from an early January $55 to fresh record highs of $72.81 per barrel has had a strong effect on the USDCAD exchange rate. Interest rate worries notwithstanding, the performance of oil may hold the key to USDCAD performance through the medium term. Given that the commodity price shows few signs of slowing, we may see it continue to support overall Loonie gains. Of course, such high oil and other energy costs can act as a double-edged sword; Canada is one of the largest per-capital energy users across the global economy.
[B]Energy Prices Crimp Disposable Income, but Consumers Continue to Spend[/B]
Overall employment and wage gains have been one of the main drivers of overall domestic expansion, with the national unemployment rate now at 33-year lows through May. Little wonder then that Retail Sales has grown at an impressive 4.8 percent year-over-year rate. If the overall export economy is to weaken expansion as expected, domestic producers will become increasingly dependent on Canadians to maintain overall production levels more or less constant. If an export slowdown hurts overall employment levels, however, we could easily see scaled back consumer spending and it is one of the many risks to economic expansion and Canadian dollar performance.
[B]CAD Supported Through Near Term Momentum, but Currency Shows Kinks in Armor[/B]
The questions surrounding the future of Canadian interest rates remains the central concern among Loonie bulls, but there are other key factors that may likewise influence currency performance. Some speculators argue that CAD gains based on higher yields have come close to their end… However ,such an argument largely depends on whether inflation remains within the Bank of Canada?s stated comfort levels through 2007. Given the fact that the loonie stands at multi-decade highs, the BoC expects that falling import costs and slowing growth in domestic export sectors will be enough to moderate economic activity through the period.
In a somewhat unusual move for any central bank, the Bank of Canada claims that recent Loonie appreciation has gone beyond what historical experience would suggest is warranted given the fundamental factors surrounding the economy. Though it has plainly said that it will not intervene in forex markets, such an assessment from a respected source certainly suggests that CAD gains may reverse. In a perhaps ironic twist, the USDCAD?s declines may in fact be the Loonie?s undoing; the net economic side effects of the appreciated currency may return the Canadian economy to slower growth and limit the attractiveness of the domestic dollar.
[B]Conclusion: Will We See USD/CAD Hit Parity?[/B]
With USD/CAD at 30 year lows, the question on everyone?s mind is, will it hit parity (a 1.0 USD/CAD exchange rate)? At this point, it seems somewhat unlikely that we will see parity. We believe that a rebound remains the more probable outcome, but there are nonetheless significant risks to this outlook. If the Bank of Canada unexpectedly raises rates faster or by more than expected, the USDCAD could make a clear run towards the critical 1.0000 mark through year?s end. To a lesser extent, a continued rally in the price of Crude Oil would also lend the Loonie support in its march towards equal terms with the US dollar. Otherwise, we would have to see a significant extension in greenback declines to sustain the USDCAD downtrend. Absent any of these three key factors, the Canadian dollar is unlikely to rally to parity against its US dollar and instead should lower through the second half of 2007.
[B]Technical Outlook[/B]
The USDCAD is likely forming a significant low and the chart below illustrates why. The decline from the 2002 high of 1.6189 is in its 5th wave and the 5th wave is a large ending diagonal (a pattern that we have seen quite a lot of lately). The support line from the diagonal is at 1.0385 this week and decreases about 9 pips per week. If indeed an ending diagonal is unfolding, then the USDCAD must bottom before 1.0070. This is where wave 5 (beginning at 1.1875) would equal wave 3 of the diagonal (1.2732-1.0927). There is no evidence that a bottom is in place but the risk of a reversal is high.
[B]USD/CAD Weekly Chart (Source: TradeStation 8.2)[/B]