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Poloz faces dilemma as loonie strengthens

Bank of Canada Governor Stephen Poloz speaks at a press conference in Ottawa in January.


Rising oil prices, stronger than expected inflation and U.S. economic stumbles in the first half of the year have combined to take the lure out of shorting the Canadian dollar.

The reversal in sentiment is also causing new headaches for Bank of Canada Governor Stephen Poloz, who has counted on a weaker currency to boost exports and help drive the economic recovery.

With the economy still underperforming and unemployment stubbornly high, the strengthening dollar may outweigh fresh concerns about inflation at the bank's policy-setting meeting next week.

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Bets by hedge funds and other large speculators last week on a rising loonie outnumbered those counting on a decline for the first time since early 2013, the latest report from the U.S. Commodity Futures Trading Commission shows.

The CFTC, which regulates futures trading in the U.S., reports weekly on the size and direction of positions held by large traders across all maturities.

The net positive position in the Canadian dollar wasn't large – only $253-million – but the change in the market's attitude was striking. In the previous CFTC report, the net short position totalled $500-million. And it was as high as $6-billion earlier this year.

"There's a bit of a herd mentality in markets, and the Canadian dollar was being heavily dumped on in a one-way bet," said Avery Shenfeld, chief economist at CIBC World Markets. "What the market had ignored was that as global growth did a little better and commodity prices showed some upside, one of the negatives for the dollar – the trade deficit – could start to look a little more positive."

Yet as recently as March, the dollar hit a nearly five-year low against its U.S. counterpart, after Mr. Poloz mused about further interest rate cuts to combat the risks of falling inflation.

But in May, consumer price inflation climbed 2.3 per cent annually from a year earlier, exceeding the Bank of Canada's 2-per-cent target for the first time in 16 months.

The loonie went from being the worst-performing industrial currency in the first quarter to the best-performing in the second quarter. It now stands at close to 94 cents (U.S.) "That change was an important one because it wasn't [based] on just one single fundamental piece. It was on all of them," said Camilla Sutton, chief currency strategist with Bank of Nova Scotia.

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The drivers for the shift to a more balanced market view of the loonie's prospects include higher than expected oil prices, the rise in both Canadian and U.S. inflation and an improving economic outlook, including signs that housing will remain healthier than skeptics have predicted.

"Those pieces all combine to help create that stronger Canadian dollar," Ms. Sutton said. "Our core takeaway is that it is likely too strong where it sits now. However, it's unlikely to go back to the lows of the year."

That poses a conundrum for the Bank of Canada. It has always denied talking down the value of the dollar. But until recent weeks it had managed to do just that through key changes of tone over the past year since the departure of former governor Mark Carney, Bank of Montreal economists said in a recent report. These included shifting to a neutral stance on future interest-rate moves and signalling a willingness to cut rates further.

"It's conventional wisdom that they would openly welcome a weaker currency. But they don't want to be quite that blunt about it," said Douglas Porter, chief economist with Bank of Montreal.

By contrast, other central banks with overvalued currencies have had no qualms about preaching the importance of depreciation to their export-driven economies. Last week, Sweden's Riksbank surprised markets with a steep interest-rate cut, and Australian central bank governor Glenn Stevens bluntly warned investors that they were underestimating the risk of a steep decline.

In the Bank of Canada's case, it is expected to stay on its current monetary course. But it will have to be cautious about how it explains itself, analysts warn.

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If the bank's statement is "surprisingly hawkish," implying that a return to higher interest rates is closer than what's being priced into the markets in response to inflation concerns, it risks triggering "a major shift in expectations" that would drive the loonie up sharply, Ms. Sutton said.

The economic fundamentals indicate a dollar in the 91- to 92-cent (U.S.) range, a level at which the central bank would feel a lot more comfortable, Ms. Sutton said.

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About the Author
Senior Economics Writer and Global Markets Columnist

Brian Milner is a senior economics writer and global markets columnist. In a long career at The Globe and Mail, he has covered diverse business beats, including international trade, the automotive industry, media, debt markets, banking and the business side of sports. More


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