- Prayer for the Canadian dollar
- Loonie down to 76 cents
- Markets at a glance
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- Nike ads dip
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Just a prayer won't do it: The Canadian dollar's fortunes rest with NAFTA negotiations and central bank interest rate decisions.
For some time now, the loonie has been bounced around by developments related to the North American free-trade agreement, tending to rise when a revised NAFTA seemed doable and fall when it appeared in jeopardy.
Case in point: The currency's tumble Friday when Canada-U.S. talks soured, missing what was said to be a deadline to sign on to a pact struck between the Americans and Mexicans earlier in the week.
Such currency fluctuations, of course, affect Canadians travelling in the U.S. (where many would have been as their summer vacations wound down), exporters and importers, traders and others.
Markets will be watching closely both as NAFTA negotiators go back at it Wednesday, and the Bank of Canada releases its rate decision the same morning.
The central bank is widely expected to hold its key overnight rate steady at 1.5 per cent, but raise that benchmark by one-quarter of a percentage point at its next meeting in October.
That’s the scenario priced into where the currency sits now, but key will be what Bank of Canada Governor Stephen Poloz, senior deputy Carolyn Wilkins and their colleagues signal in their statement, as rising interest rates are loonie-friendly.
“With very low odds of a hike at the September BoC meeting, it is doubtful USDCAD will be affected much by Wednesday’s decision unless accompanied by materially different statement language, which is not our baseline,” said Carlos Capistran, Canada and Mexico economist at Bank of America Merrill Lynch, currency strategist Ben Randol and rates strategist Olivia Lima, referring to the U.S. dollar versus the loonie by their symbols.
"The market is priced at roughly 80-per-cent probability of a hike by the 24 October meeting, and we think the BoC is likely to go ahead and deliver such a hike absent unforeseen negative surprises," they said in a lookahead to the central bank decision.
Of course, "if no trade deal involving at least Canada and the U.S. is reached soon, if negotiations break apart, the market is likely to price hikes away and the central bank is likely to slow hikes," they added.
Which would drive the loonie down. And it will be interesting to see if the central bank flags the trade uncertainty in the statement.
But “while NAFTA uncertainty lingers, the BoC has stated that they will not respond to headlines but rather to the economic data itself,” noted Sue Trinh, Royal Bank of Canada’s head of Asia foreign exchange strategy in Hong Kong.
Bank of America’s Mr. Capistran, Mr. Randol and Ms. Lima have an interesting forecast for the loonie, pegging it at just shy of 73 US cents in the fourth quarter.
"That said, we are carefully monitoring the outcome of ongoing U.S.-Canada trade discussions, which could well have a positive impact on reducing investor uncertainty, a key source of Canada's [balance of payments] weakness," they said.
"A deal in principle that is taken as credible and implementable by the market could turn investor sentiment around, leading to a more sustainable external financing situation as well as BoC confidence in the interest rate normalization process."
Indeed, observers have forecast that the Canadian dollar could bounce to 80 US cents or higher if a deal on NAFTA is reached.
“When looking at trade, the risk to the Canadian economy is greater than that of most major global economies,” said Toronto-Dominion Bank senior economist James Orlando.
"The U.S. makes up 49.4 per cent of the trade-weighted Canadian dollar index," he added in a recent report.
"When Canada is facing a disproportionate economic threat from the U.S., the Canadian dollar adjusts accordingly. It just so happens that the other economies that have been in the tariff purview are also the next most important to Canada with respect to trade - China (13.1 per cent of total), Europe (11.1 per cent), and Mexico (8.5 per cent)."
That trade-weighted measure has gained about 2 per cent since March, Mr. Orlando said, but 6 per cent if you remove the U.S. dollar from the equation.
“We believe that this rally, which attests to Canada’s recent economic strength relative to most major economies, has left the Canadian dollar at or above fair value versus the currencies of major trading partners, with the exception being the greenback,” he said.
Mr. Orlando cited other reasons for the loonie’s gains, but the biggest driver is hope for a trade deal.
“If a deal is indeed struck, we would expect significant appreciation in the loonie and even a potential overshoot from the 80-82 US cent equilibrium rate. If not, the trade discount would certainly increase and the loonie could retest the 75 US cent level.”
Bipan Rai, North America head of foreign exchange strategy at CIBC World Markets, and his colleague Sarah Ying said the bank is often asked how the loonie would fair should a deal be struck or the "TAFKAN (Trade Agreement Formerly Known As NAFTA") die.
“Our answer remains the same – there are more downside risks than upside over the longer-term,” Mr. Rai and Ms. Ying said in a report.
"Our in-house models indicate that the NAFTA premium is worth a scant 1 per cent in spot USD/CAD right now – a number that appears abnormally small considering the importance that the trade agreement has in our economy," they added.
"But let’s assume there’s a deal struck in the coming weeks or months and Canada is back in a trilateral agreement. From wherever spot is at the time, you can count on the CAD to surely strengthen by at least 1 per cent as the premium is removed and maybe a bit more beyond there on flows and positioning. But sustained momentum beyond that would be difficult, or the start of a windfall CAD rally? That’s a bit tough for us to envisage."
That, said Mr. Rai and Ms. Ying, is because concerns over NAFTA don't appear to be suppressing business investment or economic growth. And if there's no deal, talks could still continue and, regardless, the U.S. Congress could sneer at an agreement that cuts Canada out.
The markets wouldn't have to quickly "reprice" into the loonie what the Bank of Canada could do under the first scenario, but possibly would under the second.
"Longer-term, the CAD is still at risk given that the BoC is closer to its neutral rate than most other central banks, and liquidity withdrawal will become a concern to watch for in the coming quarters," Mr. Rai and Ms. Ying said.
“Additionally, the lack of pick-up in non-energy exports supports the view that the external sector requires a cheaper CAD to maintain competitiveness over the long-term.”
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