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A Canadian dollar coin is pictured in this illustration picture taken in Toronto.

© Mark Blinch / Reuters

The Canadian dollar will weaken in the coming months, as the Federal Reserve is expected to continue increasing rates while the Bank of Canada is bound to stay put, according to the currency's highest-ranked forecasters.

The loonie started strong in 2017, recovering from a 10-month low at the end of 2016 by taking advantage of January's broad-based decline in the U.S. dollar. But it has faltered in recent weeks, reducing this year's gain to 0.6 per cent, lagging most Group of 10 currencies.

While Canada's economy has shown signs of improvement lately, posting higher-than-expected growth, retail sales and jobs numbers, that hasn't been enough to convince Bank of Canada Governor Stephen Poloz of the need to raise interest rates. The Fed, on the other hand, has hiked twice in the last four months and is on track for additional increases as the U.S. economy picks up. That will put pressure on the Canadian dollar, according to Scott Petruska, a senior adviser at SVB Financial Group of Santa Clara, California.

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"I'm in the camp that thinks the U.S. dollar is going to be strong," said Petruska, who topped a Bloomberg ranking of Canadian dollar forecasters in the first quarter and expects the loonie to slip almost a penny to C$1.35 over the next six months. "Canadian volatility is very low, and when volatility is low that's where the interest rates differentials become the dominant theme."

Volatility Down

The loonie rose 0.4 per cent to C$1.3364 per U.S. dollar at 9:43 a.m. in Toronto, curbing this week's loss to 0.3 per cent. Thirty-day implied volatility in the currency fell to the lowest since October 2014 this month, according to data compiled by Bloomberg.

The currency's gain on Friday came on the back of jobs data for March, which showed an increase in net employment in Canada's economy by 19,400, triple the median forecast in a Bloomberg survey. Yet the pace of annual wage rate increases fell to 1.1 per cent, the lowest since the 1990s, deepening a puzzle for policy makers who have been perplexed by the conflicting trends in the country's jobs market.

The Canadian dollar will also suffer from a likely slowdown in economic growth in the U.S. and China, which will filter through to the Canadian economy, according to David Doyle, a North American economist at Macquarie Capital Markets Ltd., who came in second in Bloomberg's ranking of loonie forecasters.

"We're seeing faltering global growth momentum," Doyle said, adding that he expects the Canadian dollar to weaken to C$1.53 by the end of the year, the most bearish forecast of all analysts surveyed by Bloomberg. "Monetary policy divergence that has been a big driver of the Canadian dollar in the past four or five years is likely to continue and become more and more exacerbated."

Policy Divergence

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The Canadian economy has more room to grow than its American counterpart, Poloz said in an interview with Maclean's magazine last week, pushing back against the idea that he would soon follow his peers in lifting interest rates. Traders still see a 27 per cent chance the Bank of Canada will hike this year, according to overnight index swaps. The next rate decision is on April 12.

It's a different picture south of the border. The Fed raised borrowing costs for the first time in a year in December and followed up with another increase last month. Minutes from that meeting released on Wednesday showed that apart from backing further rate increases, most Fed officials were in favor of shrinking the central bank's balance sheet, which has swelled from three rounds of bond purchases from 2008 to 2014.

"The central bank policy divergence is still one of the key issues facing this marketplace," said Amo Sahota, director of risk management at San Francisco-based FX Klarity Inc., who came third in Bloomberg's ranking. "Canadian interest rates aren't going anywhere. Meanwhile, for U.S. interest rates we're still expecting two, if not three, rate hikes this year. As it stands right now, we still feel that the directional bias is going to be higher for the U.S. dollar."

Currency forecasters are ranked by Bloomberg based on the margin of error for their calls, timing and directional accuracy.

–With assistance from Wei Lu

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