The Canadian dollar, among the best performing currencies over the first three quarters of 2007, saw an abrupt and extensive retracement through the final months of the year. However, this turn in fortunes didn’t come before significant records were broken. Towards the end of the third quarter, the Canadian dollar was pushing multi-decade highs against its US counterpart. Soon thereafter USDCAD dropped to parity, then to a 165 year low and finally a record low of 0.9055 before finally exhausting its run. Despite suggestions from a number of analysts and even the central bank that the exchange rate between the Canadian dollar and its largest trade partner could be sustained below parity, the market seemed to see things differently. The November/December rebound which took USDCAD back above 1.0 could easily be attributed to a technical rebound - a natural response to the remarkably consistent momentum from the break below 1.05. However, now with bullish convictions broken, fundamentals will likely play a bigger role in creating a market-based equilibrium rate for the loonie that is likely to be considerably lower that just a few months ago.
Tell Us Where You Think the USD/CAD is Headed in 2008 on the DailyFX Forum.
Bank of Canada Cuts, Interest Rates Come To The Forefront
One of the key factors for the USD/CAD’s steady declines through 2007 was the difference in monetary policy stances between the US and Canadian central banks. The Bank of Canada raised interest rates by 25bp to 4.50 percent in the month of July while the Federal Reserve cut the discount rate by 50bp in August. This triggered a sharp sell-off in USD/CAD that took the currency pair from 1.06 down to 0.9059 in a matter of 2 months. However, all of that changed on December 4th when Governor David Dodge and his fellow policy makers cut rates 25 basis points to 4.25 percent. This easing caught a majority of economists and market participants off guard. Growth trends were still deep in the black thanks to both domestic and export growth trends; and the risks to inflation were suspected to remain to the upside thanks to record energy prices and the rising cost for food.
Despite the hawkish outlook coming from outside the central bank’s ranks, the forecast from monetary policy officials was quite different. Officials remarked that price pressures were below their own forecasts; and they expected them to remain so for at least the next several months. The cooling in inflation was attributed to the rapid ascent in the Canadian dollar, which lowered the prices of imported goods and eroded the country’s competitiveness on the global market. As for their growth outlook, the policy group made note that domestic growth was in line with their forecasts, commodity prices were strong and global economic expansion was robust. However, they had also suggested the difficulties in global financial markets would likely “persist for a longer time” and its unknown influence could have a profound effect on growth and inflation trends going forward.
Considering the substantial revisions to the central bank’s expectations, there has been a clear change in interest rate expectations. If underlying inflation trends continue to flounder below the BoC’s two percent target rate and credit conditions fail to improve, BOC officials will likely lower the benchmark lending rate further. The direction of Canadian lending rates will certainly be a major influence over loonie price action over the coming months, but Canadian rates will not be the only factor for USDCAD movement – US rates will be equally influential for the pair. Looking at the graph below which plots spot USDCAD against the spread between two-year US and Canadian interest rates, it is clear that the yield differential between the two currencies has guided spot If the Federal Reserve consistently lowers its primary lending rate while the Bank of Canada eases policy at a much more restrained rate the differential may work to keep the USDCAD near parity. Whether or not the Canadian monetary policy authority takes the Fed’s lead will undoubtedly rest in fundamentals, the conditions of financial markets and the guidance of the new Governor who will take over for David Dodge upon his retirement on January 31st.
Oil Still On The Rise, But Will It Help The Loonie?
Though a record Canadian dollar has dampened inflation forecasts and altered the course of interest rates, commodities remain one of the nation’s key cash cows. In fact, shipments of commodities like oil, natural gas, gold and paper products account for nearly half of Canadian exports. And, while the commodity boom from years past is not taking the lead on growth trends going into 2008, it will no doubt support the merchandise trade balance as other export sectors take a hit from the unfavorable exchange rates. Commodities are able to weather the adverse circumstances as demand is relatively constant and prices continue to rise. Foreign demand for the preeminent Canadian export – crude oil – has only risen through the final months of 2007 as OPEC producers have refused to increase output even though growth trends in the US and China (two of the world’s largest economies) hold near four year and 13 year highs respectively. This divergence between supply and demand has clearly been reflected in prices. The US standard WTI crude contract soared to a record $99.29/barrel on November 21st. While prices have since backed off from these highs, they have not fallen much further than $90/barrel.
Looking ahead, the demand for this primary energy commodity is not likely to abate on its own. The only true threat to a serious retracement would be a slowdown in global expansion However, even if prices for the energy complex and other raw materials remain elevated , there is no guarantee that they will continue to benefit the Canadian economy on balance. In fact, the frequently referred to 50-day correlation between the USDCAD and oil has deteriorated considerably over the past few months as other fundamental concerns - whether it be a technical reversal in the currency rally, a change in interest rates expectations or some other issue - crowd the relationship out. What’s more, record raw material prices are as much a burden on the domestic economy as they are to the foreign countries that purchase the necessary goods as exports.
Export Sector Continues To Suffer
While commodity shipments have weathered the worst of the Canadian dollar’s meteoric rise, other sectors of the economy have not been so lucky. Unlike raw materials, demand for manufactured Canadian exports will wane while the national currency appreciates as domestic businesses are no longer competitive on the global market. Though the unfavorable impact of the rising Canadian currency has been masked in relatively strong trade numbers through most of the year, cracks were clearly starting to show in the fourth quarter. The international merchandise trade surplus sank in September to C$2.65 billion - its smallest positive gap since 1998 - proving that this was not simply a one-off event. Meanwhile, the current account balance, the country’s broadest measure of trade, dropped from a surplus of C$6.35 billion in the second quarter to a more than four-year low C$1.039 billion positive balance.
Looking ahead, the health of the manufacturing sector isn’t expected to improve if Canada’s exchange rate remains near record highs against its largest trading partner. Realistically, Canadian producers may continue to suffer for a number of months going forward even if the currency sees a steady pullback from its highs. Such dour forecasts are rooted in the significant declines in demand and investment through 2007. According to Statistics Canada, new orders at factories fell nine out of ten months in the year through October. What’s more, even if orders rebound, production capacity may not even be able to meet the demand as employment across the sector has dropped precipitously. Though nationwide employment grew relatively consistently over the past few years, bringing the jobless rate to a 33-year low, factory-based jobs steadily vanished over the same period. Over the 12 month period through November, manufacturing payrolls dropped by 91,600 jobs.
Domestic Demand Still Strong, But Outlook Poor
Despite the notable slowdown in manufacturing activity, though, the broader economy was running at an impressive clip through the end of 2007. Despite decelerating for the second consecutive quarter, annual expansion measured 2.9 percent through the third quarter of the year – well above 2006’s trends. Leading the charge was the Canadian consumer. Personal spending rose 3.0 percent through the quarter, encouraged by the multi-decade low in the joblessness and the strongest pace of wage growth on record. Another clear component of consumer confidence and overall contributor to healthy growth was the strength in the housing market. While the US residential market was sliding into its worst recession since WWII through the closing months of the year, demand for Canadian homes was consistently outpacing supply. Assisting demand, housing prices have not reported a monthly decline since August of 1998. Yet another strong addition to growth came through business spending. Taking advantage of the high loonie, businesses increased spending on machinery and equipment by 15 percent through the third quarter. At the same time spending on inventory rose C$15 billion over the same period.
However, these strong trends can’t hold out forever. In fact, the components for a considerable slowdown are already in place. As the global economic winds begin to die down, the chills will eventually spread to the Canadian economy. The first sector to downshift will most likely be the sensitive export market. As we suggested above, manufacturers who ship their wares outside of the nation’s borders are already at a disadvantage due to their unfavorable exchange rates. Add to that a general decrease in demand from trade partners and even the most robust exports (i.e. commodities) will see a decline in demand. Entrenched problems in the credit markets and production and hiring trends will likely follow suit. From there, the primary engine for growth will sputter as consumer spending and housing market strength will weaken without employment and wages to raise wealth and consumer confidence.
Canadian Dollar Already On The Turn
And, finally, looking past all the fundamental influences pushing and pulling exchange trends, sentiment surrounding the loonie itself will undoubtedly have its impact on the currency. From its 2002 high, USDCAD dropped over 44 percent to its record low through the final quarter of 2007. What’s more, this decline wasn’t steady over the past five years. In 2007 alone, the pair plunged 24 percent. Such trends in the currency market rarely go uncorrected. Aiding in a rebound will be the presence of the psychologically-important parity level. The market often yields to even numbers; but parity has another level of influence on long-term trends.
Key Points
Canadian fundamentals at the end of 2007 were clearly supportive of a strong loonie Economic expansion was firmly backed by exports and business and consumer spending trends. What’s more, seemingly insatiable global demand for raw materials boosted the commodity appeal of the Canadian dollar. However, despite these trends, many cracks had developed that threaten the loonie’s reign in the currency market in 2008. The one way rally of 2007 has depressed trade flows. Another concern is that global growth trends have begun to cool, further exposing the lack of competitiveness Canadian businesses have in the global market and even threatening the demand for commodities. As a corollary to fundamentals, interest rates will also have a considerable impact on the Canadian dollar’s direction. With the first BoC rate cut out of the way, it will likely be easier for the Canadian monetary officials to follow up with further easing – putting further downward pressure on the loonie.
USDCAD Technical Outlook: Pattern Depends on How Far Current Losses Extend – By Jamie Saettele
We wrote last quarter that “the USDCAD looks like it could chop lower before registering a significant low. Zooming in on the daily, it appears as though the decline from 1.1875 is in its 5th and final wave. The 5th wave began at 1.0866 and does have the potential continue lower but potential support is at monthly pivot support (.9695).” In typical blow-off fashion, USDCAD reached .9055 before reversing violently and hitting 1.0248. Is the rally off of .9055 the first leg of a more significant bull move? That depends on what the decline from 1.0248 unfolds as. If the decline ends up as a 3 wave correction (which is often the longest but never the shortest), then an aggressive bullish bias is warranted against .9055. Potential support is at the 61.8% of .9055-1.0248 at .9511. Price remains below a resistance line drawn off of the March and August lows, but a break above that line would support a major bullish reversal.
