Stephen S. Poloz, Governor of the Bank of Canada. Image via Bank of Canada.
CAD Best Performer Against US Dollar
Since the election of Donald Trump, the Canadian Dollar is the only of the major currencies to be up against the US Dollar. Firmer Oil prices were responsible for driving CAD eleven cents higher against the Dollar, though eight cents of that was conceded in response to rising Fed tightening expectations.
This dynamic was consistent with the pre-election environment. Post-election however, the correlation with Oil prices was significantly higher. Looking ahead over the rest of the year the potential for further upside in Oil will be limited as supply eventually increases. When positioning is extreme, the Canadian Dollar is particularly vulnerable to lower Oil prices, especially when combined with an equity correction.
Poloz to Turn More Hawkish
In terms of gauging the likely direction for USDCAD, policy differentials and politics are likely to weigh in the short term before price then recovers. Markets could begin to turn price in a higher likelihood over a BOC rate hike as Poloz potentially turns more hawkish at the upcoming BOC meeting given that the Canadian economy has continued to perform well. However, measures intended to cool down the surging housing market should have increasingly negative effects on CPI.
At the same time, the probability of a foreign tax in the buoyant Toronto market should increase. The big issue that is yet to be addressed is the proposed tax on exports to the United States at a time when Canadian productivity is still very low. It should already dampen investments and weaken potential growth. In light of this, the BOC could threaten to tighten but is unlikely to move to do so in a hurry. Instead, the officials might look to put more pressure on the housing market, keeping CPI under target.
Although expectations for the Canadian economy have improved post-election, expectations for the US economy have increased far more. Two-year interest rate differentials have moved twenty basis points in the US Dollar’s favour. For two such interlocked economies, the movement is surprisingly significant as the spread between the two has been +/- 100 basis points since 2006.
Optimism in the wake of the US election has faded somewhat with the yield on 10Y US paper down thirty-five percent from the post-election peak. However, optimism is likely to pick back up again as the labour market is tightening, regardless of the speed of policy implementation through Congress.
Oil In Focus
Although Oil prices have recovered firmly since the US election, its dynamics are becoming less favourable. OPEC production cuts were responsible for fuelling the rally in Oil prices pushing speculator positioning near to all-time highs at a time when the IEA finally forecasts an increased in US shale production.
Rising production should eventually cap upside traction in Oil prices. However, the supply takes time to increase as it involves exploration, drilling, and extraction. Since May 2016, the Baker Hughes rig count has consistently increased at a constant pace and is forecast to continue to do so.
For now, Oil prices are remaining above the prior 2016 highs which are acting as support though bullish momentum has clearly stalled.
Going forward, the resilience of the Canadian Dollar depends on continued equity flows supported by higher Oil prices. Lower oil/equity prices would leave the Canadian Dollar particularly vulnerable given heavy foreign ownership in Canadian equities and oil positioning. In particular, the S&P/TSX energy sector is quite large and the overall index is expensive when compared to the S&P500 on a P/E basis.
For now, USDCAD is sitting at a key juncture. Having broken down below the rising trend line from last year’s lows, USDCAD is now challenging structural support at the September and October 2016 lows at 1.2995 along with the 50% retracement from last year’s lows at the current level of 1.3027. The recently broken December 2016 low now sits just above as resistance.