Market events since the publication of our 2020 outlook have forced us to revise our short-term USDCAD forecast upwards.
Our 2020 outlook, written back in December, discussed how USDCAD would break the $1.30 barrier in the second half of 2020 should the US and China sign a phase-one trade deal.
While the narrow trade deal was signed and the loonie broke the $1.30 barrier in the early part of January 2020, in part due to rising tensions in the Middle East spurring oil prices higher, the rally didn’t prove sustainable.
A double whammy of a dovish Bank of Canada meeting on January 22nd and news of the coronavirus outbreak in China reversed sentiment in the Canadian dollar. USDCAD soon found itself trading in the $1.32 range, with the $1.33 barrier falling shortly after. A further deterioration in risk appetite now sees USDCAD trading up near $1.35.
Given the fact that recent FX pricing has been driven by exogenous and unpredictable shocks, we maintain our view of a stronger Canadian dollar in the longer-run due to the structural outperformance of the Canadian economy relative to other developed markets.
However, the ensuing impacts of the coronavirus on the global economy have forced us to trim our bullish CAD expectations in the short-run, with risks skewed towards a further weakening of the Canadian dollar.
External headwinds have re-emerged in the shape of the coronavirus
In December’s meeting, with a narrow trade deal seemingly on the table, the Bank of Canada struck an optimistic tone that led to markets trimming the prospect of an insurance rate cut in the near future.
However, the optimism wasn’t shared by the Governing Council in January’s meeting due to slowing economic activity in Q4 threatening the bank’s outlook coming into the new year.
The dovish tone struck by Governor Poloz the second time around led to the largest daily USDCAD move year-to-date, with the currency pair jumping half a percentage point open-to-close.
With domestic macroeconomic conditions already a concern, external headwinds to the economy, which previously took the form of US-China trade tensions, re-emerged in the repackaged form of the coronavirus.
Initially, the Canadian dollar weathered the storm that faced many open economies linked to commodity markets as investors flocked to safer assets. The higher yield on Canadian government debt propped up the loonie, but this support was short-lived. The impact of the virus on tourism expenditure and oil prices pushed USDCAD above the $1.33 barrier, which it previously failed to break before oil prices dipped below $50.
Chart: US-CA 2-year yield spread points to a loonie rally should the BoC remain on hold and risk appetite improve
FX markets have priced the growth shock more aggressively than fixed income markets, which view March’s meeting as too premature to expect a rate cut.
The probability of a rate cut implied by Overnight Index Swaps has barely moved since the last Bank of Canada meeting, with swap markets still pricing a roughly 50% chance of a 25 basis point rate cut in April’s meeting.
We maintain that despite a slowdown in growth in Q4, the Canadian economy continues to grow at a resilient but low level, supported by a tight labour market.
Preliminary activity data for Q1 suggests that concerns of lower domestic activity look stretched. However, this view is subject to change should official data from China highlight a more substantial slowdown in global growth which will likely drag on economic activity domestically.
With Canada’s economy exposed to external growth conditions, data for February will prove key in assessing the impact the coronavirus had on domestic activity, and therefore predicting the next steps taken by the BoC.
That being said, we believe the bar to further monetary easing is high, a view fixed income markets are similarly sharing, due to fears of spurring a housing bubble. We expect BoC policy to follow a similar pattern to that of 2019 – dovish tones without a material adjustment.
Chart: OIS pricing of rate cuts in the next two BoC meetings have barely changed since the January 22nd meeting despite the increasing risk of a coronavirus induced slowdown
Without another substantial demand-side shock we believe WTI will remain supported around the $50 level, conditional on further cuts by OPEC in March.
Crude markets have arguably priced in the ensuing fall in demand from the coronavirus outbreak, with the epidemic shaving nearly $10 off the price of a barrel of WTI.
With OPEC+ weighing up further production cuts conditional on Russia’s agreement, we believe oil prices have likely bottomed out for the time being.
Oil prices are a major risk to the loonie outlook.
However, the length of the containment programme in China is key for assessing how entrenched the demand shock truly is. Additional risks come in the form of production cuts, which are not a foregone conclusion.
Neither additional cuts, nor the extension of the current policy have been confirmed by officials. Market participants are now looking to the March OPEC meeting to provide more clarity on the issue.
A lower oil price not only hinders Canada’s current account, but also investment in the industry. This was the theme for much of 2019 and could further drag on economic activity if sustained.
Author: Simon Harvey, FX Market Analyst at Monex Europe.