The contrarian bullish case for Canadian dollar
The canadian dollar was the natural victim of king dollar, the recent decline in oil prices, the money markets softness on interest rate expectations from the Bank of Canada and a surprise GDP miss. However, the real shocker of the week was the Trump White House’s decision to impose tariffs on steel and aluminium imports from the EU, Canada and Mexico — and Ottawa’s decision to retaliate against American metal imports. It is a farce that the US Commerce Department has used national security as the smokescreen to impose sanctions against one of America’s oldest, closes allies. This suggests a near term agreement on Nafta is not on the horizon, though disagreements on a “sunset clause” does not necessarily preclude a final deal. Yet it is undeniable that the tone of Ottawa — Washington trade diplomacy has deteriorated and the loonie’s cost of protection in the foreign exchange options market has risen. The blowout 223,000 May nonfarm payrolls data will pressure the Canadian dollar as June FOMC rate hike is certain. Yet I am convinced that the Canadian dollar is undervalued in the 1.30-1.32 range. Why?
One, rate expectations have softened excessively in the past month. Though the Bank of Canada was on hold at its interest rate conclave, there is no doubt that Ottawa can and will shadow the Yellen Fed’s monetary tightening over time.
Two, Planet Forex has priced in a dire endgame to the Nafta trade talks in Washington. Yet Justin Trudeau and Foreign Affairs Minister Freeland have offered significant trade concessions to Trump and a Nafta deal can and will happen. This will trigger a global buying wave in the Canadian dollar.
Three, the significant improvement in Canada’s terms of trade in 2018 is not reflected in current levels. The last MFR projects $60 West Texas and $40 Western Canada select, well below current levels. Lumber and soft commodities prices also contribute to better Canadian terms of trade. This fact alone suggests no premature central banking ease in Canada, a factor that will reinforce a bullish tone to the Canadian dollar.
Four, Canadian money market forwards imply only one rate hike in September. Yet this makes no sense given the momentum in domestic economic growth data, positive smoke signals from Nafta and resilient, even strong domestic data driven by commodities markets. Two rate hikes until December seem far more likely, a scenario that is bullish for the loonie. La Bella Italia is always a wild card for investors and central bankers, but I believe domestic data, Nafta, housing and terms of trade will be the main factors that will influence the Bank of Canada’s strategic rate setting calculus.
Five, Chicago futures speculative positioning data reinforces my cautious optimism. The downtrend line from the 1.46 lows in mid-2016 suggests the Canadian dollar faces technical support at the 1.30-1.32 levels.
Six, Governor Poloz has made it clear that his main policy focus is his 2 per cent inflation target, not the violent mood swings of Club Med politics. The Bank of Canada statement was unambiguous that “higher interest rates will be warranted to keep inflation near target”. The Canadian central bank noted its two per cent GDP growth forecast and pointed to the gasoline price driven rise in inflation above two per cent. It does not surprise me that the implied probability of a July 11 rate hike by the Bank of Canada has risen from 53 per cent to 75 per cent after the Ottawa central bank conceded that the economy has outperformed in all sectors apart from housing relative to its earlier expectations. I find it significant that events in Turkey, Argentina or global equities did not preclude a hawkish Bank of Canada statement. This is bullish the loonie.
There are three scenarios where I can envisage a freefall in the Canadian dollar, possibly to as low as the 1.46-1.48 levels we saw two years ago. One, a Lehman like banking shock in Europe. Deutsche Bank has $25 billion in capital and 1.8 trillion in liabilities. Its share price has plunged from 90 euros in 2007 to nine now. The cognoscenti of international finance have obviously bailed out of the German banking colossus that has hemorrhaged shareholder value. Two, a collapse in oil prices. Three, a major blow up in the $2 trillion Canadian household debt time bomb. If these events happen, the Canadian currency will be fool’s gold and no place to hide for Gulf investors.