The Canadian dollar expected to fall to 1.36 against the greenback.
Bank of Canada would be forced to turn even more dovish due to mediocre job/economic growth
Published: Sun 14 Aug 2016, 3:00 PM
Updated: Sun 14 Aug 2016, 5:52 PM
- By
- Matein Khalid Currencies
Foreign exchange rates reflect relative economic growth, interest rate spreads, central bank policies and reliance on commodities exports. This is the reason I recommended UAE investors to take profits on the Canadian dollar at 1.25, as I thought the US economy would reaccelerate, the Yellen Fed would abandon its dovishness and the global oil glut would pressure West Texas crude while the Bank of Canada would be forced to turn even more dovish due to mediocre job/economic growth. This is exactly what has happened. US July payrolls added a fabulous 255,000 jobs while June was revised higher to 292,000 jobs. This scale of job growth dwarfed the estimates of even the most optimistic financial markets economists on Wall Street. Not even an uber-dove like Janet Yellen can now deny that the Federal Reserve has reached the limit of its dual mandate and that the next move must be a wage hike, since the economy is at full unemployment while wage growth is rising above two per cent.
It is no coincidence that the Canadian dollar has depreciated to 1.30 in the past month. Crude oil prices, pressured by a global glut, epic gasoline inventories and Saudi Arabia's refusal to play the role of Opec's "swing producer", are down 20 per cent from their recent $50 peak. Above all, the loonie was a classic short in the currency market after the Canadian labour market contracted for two successive months while suffering its largest ever trade deficit in June 2016.
The divergence in relative central bank policies between Washington DC and Ottawa could not be more dramatic. While the Yellen Fed is forced to move to a tightening bias in the US, the awful jobs, trade and crude oil realities will force the Bank of Canada into another monetary ease, a scenario I do not think is fully priced into the current foreign exchange rate.
Ironically, the Canadian economy has weakened at a time when the US economy has strengthened, a violation of past cycles. This is the reason Fed Funds futures imply a 50 per cent probability of a US rate hike by December while Canadian money market futures imply a 32 per cent probability of a rate cut by the Bank of Canada by year end 2016. The 31,200 Canadian job losses in July and the C$3.6 billion trade deficit both mean Governor Poloz will be forced to cut rates in the next five months. This means that, sometime this autumn, the Canadian dollar will fall to 1.36 against the greenback.
Stephen Poloz knows that the Canadian dollar needs to fall even more to give Canadian manufacturing exports a competitive advantage in global markets. With an unemployment rate of 6.9 per cent, Canada's economic performance lags the US, whose jobless rate is at 4.8 per cent. Canada's job creation rate in 2016 is the lowest since the mid 1970's, excluding recessions. It is ominous that July's job losses were due to contractions in trade, construction and even the Federal government payrolls. Of course, the summer malaise in the Canadian economy was amplified by the wildfires that engulfed the oil town of Fort McMurray in Alberta. This resulted in the 15% drop in Canadian refinery output. The Alberta wildfires mean below trend economic growth and to borrow a Latin term from Econ 101, ceteris paribus, mean a more dovish monetary and fiscal stance in Canada.
Justin Trudeau's centre-left Liberal Party has raised taxes for Canada's rich and cut taxes for the middle class, as promised in its election manifesto. The Alberta wildfires impacted 25 per cent of Canada's 1 million barrel a day production but this macroeconomic setback will not change Trudeau's fiscal ideology. In any case, it is probable that Canadian economic growth in the next six months could be barely one per cent and the Federal fiscal deficit will deteriorate. With the Canadian consumer overleveraged by mortgage debt, the burden of adjustment will fall on the Bank of Canada and the Canadian dollar. There is a palpable risk of a housing bubble in Vancouver and Toronto, that only accentuates my bearish strategy call on the loonie.
The US dollar's broad based decline since July non-farm payrolls has boosted both West Texas crude and the Canadian dollar. Yet the loonie is overvalued relative to US-Canadian yield spreads and implied volatility in the option markets suggests renewed US dollar strength ahead. Our post Brexit cable short strategy was profitable as sterling had declined to 1.29.