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Headwinds building for the Canadian dollar
12/12/2017 9:24:56 AM
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By Fund Library News Wire  | Thursday, November 23, 2017


 



By Kurt Reiman, Director, Chief Investment Strategist for Canada

After a sharp 10% appreciation versus the greenback from May through September, the Canadian dollar is now sitting pretty close to its long-term fair value, as measured by purchasing power parity. Many investors are therefore wondering: Can the Canadian dollar break above its recent highs, or was this just another flash in the pan? In our view, most of the good news for the loonie is in the rear-view mirror. Here are six key reasons why the loonie could face further resistance ahead.

A slow inflationary rebound

Our BlackRock Inflation GPS points to Canada’s core inflation rate strengthening but remaining below target over the next six months, whereas we expect U.S. core inflation to return to 2%. The somewhat stronger U.S. inflation signal implies a modestly more hawkish U.S. Federal Reserve tightening cycle than what we would expect to see out of the Bank of Canada (BoC) after it left its key overnight lending rate unchanged at 1% in October. And to the extent asset prices matter to monetary policy officials, recent weakness in Canadian housing prices could warrant a go-slow approach.

Growth to moderate

The faster-than-anticipated closing of Canada’s output gap in 2017 drove the BoC to raise rates twice this summer, fully reversing the 50 basis points of emergency cuts introduced in 2015. Our BlackRock Growth GPS signal suggests GDP will level off at around 2.3% before the end of 2018, which is consistent with an above-trend economic expansion and slow enough to let the BoC take its time, follow the data and monitor emerging headwinds, such as borrowers’ sensitivity to higher rates.

High indebtedness

The Canadian economy is highly sensitive to rising interest rates given the heady pace of debt accumulation in recent years. The Bank for International Settlements singled out Canada for its accelerated growth in credit relative to GDP and for its susceptibility to a sharp rise in debt-service costs. In light of these warning signs, the BoC will likely take time to carefully observe how the economy reacts to tighter financial conditions before taking any significant next steps.

NAFTA risks

Newly imposed tariffs or a downright elimination of NAFTA could curtail Canadian GDP growth in terms of exports and delay the BoC’s rate hike process. Despite a stalled renegotiation process amid tough U.S. demands, the Canadian dollar has maintained a relatively brave face so far. Since NAFTA renegotiations began, the loonie has risen 1% while the Mexican peso weakened 7%. The Canadian dollar arguably has more room to reflect concerns of a bleak NAFTA outcome.

Short squeeze

The BoC’s lack of forward guidance whipsawed financial markets, and as a consequence, many investors found themselves suddenly offside. Futures positioning bounced from ultra-bearish to bullish in a matter of weeks, signaling that short covering potentially played a role in exaggerating the Canadian dollar’s rally. The underlying factors driving the strength of the loonie have implications on how the BoC responds; the BoC is more forgiving if a stronger dollar is driven by fundamentals (i.e., greater foreign demand for Canadian goods/services) rather than investment flows.

Range-bound oil

Oil prices have traditionally been a key driver of the Canadian dollar. We see oil continuing to trade within a narrow range, thanks to shale shifting the breakeven cost of production lower and OPEC maintaining a floor on current prices (read more here). In addition, the correlation between oil and the Canadian dollar has weakened over the past three years, suggesting that recent price swings in oil haven’t been of great enough magnitude to materially influence the loonie.

Kurt Reiman, Director, is BlackRock’s Chief Investment Strategist for Canada and is a member of the BlackRock Investment Institute (BII). Daniel Donato, analyst with BlackRock in Canada, contributed to this article.

Notes and Disclaimer

© 2017 by Fund Library. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared in the BlackRock Blog on the BlackRock Canada website.

Important information

Index performance is for illustrative purposes only. Index performance does not reflect any management fees, transaction costs or expenses. Indexes are unmanaged and one cannot invest directly in an index. Past performance does not guarantee future results.

Past performance is not a guarantee of future results. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of the date indicated and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

© 2017 BlackRock Asset Management Canada Limited. All rights reserved. iSHARES and BLACKROCK are registered trademarks of BlackRock, Inc., or its subsidiaries in the United States and elsewhere. Used with permission. 248346

 
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