At its worst point, the Canadian dollar depreciated some 10% in March as the economy was hit with the transmission of Covid-19 to North America, thus inducing lockdown measures, while markets sought safety in US dollar liquidity.
With the outbreak labelled a global pandemic when cases began to rise and lockdown measures were implemented in Europe and North America, the oil market also took a substantial hit. The price of WTI fell by over 50% in March as demand conditions crumbled, however, the worst was yet to come. In April, concerns over inventory space filling up rapidly forced near-term futures contracts to turn negative. While WTI’s dip below zero stole the headlines on the 20th April, most of the damage had already been done to the Canadian oil industry. In March, the price of Western Canada Select fell into single digits, shut-ins began to rise and balance sheets in Canada’s oil industry started to deteriorate substantially. Due to the makeup of Canada’s oil extraction, shut-ins tend to reduce the sectors output for the 12-18month horizon.
With social consumption collapsing, unemployment set to increase to levels above 2008-09, and the oil market in a state of tatters, the aggressive coordinated stimulus response from the Bank of Canada and Trudeau administration failed to prompt a recovery in the loonie. Instead, USDCAD oscillated within the 1.3850 – 1.43 range for almost two months. The loonie’s breakout only began when global risk sentiment improved on signs of scaled back containment measures in the APAC region and hard-hit European nations.
Despite the Canadian dollar currently trading near its strongest levels since the pandemic in this renewed risk environment, the situation surrounding the global economy remains fluid.
With risks plentiful and not just isolated to the course of the viral outbreak, the outlook for a sustained loonie rally is tentative. Should the global risk climate deteriorate for any number of reasons, we expect USDCAD to find refuge back in its previous range.
Loonie breaks out of recent range as global risk sentiment improves
ECONOMIC RECOVERY TO BE MORE PROLONGED THAN POLOZ SUGGESTS
Exiting BoC Governor, Stephen Poloz, recently stated that the best scenario outlined in the Bank’s latest Monetary Policy Report “is still for me the most likely scenario”. The best case scenario sees lockdown measures scaled back in both Canada and major trading partners within the next quarter, allowing for a rebound in the global economy and limited structural scarring.Under this scenario, the MPR projections suggests the Canadian economy could return to pre-virus levels as early as 2021H1 with regards to output.
This scenario seems overly optimistic in our view, especially with the heightened likelihood of a second wave in the winter months barring no vaccine, which would lead to lockdown measures being implemented yet again albeit at a less stringent level than currently.
While the C$205bn fiscal stimulus package is largely aimed at supporting households and therefore propping up consumption, we believe the underlying impacts to the Canadian consumer are being underreported in the data.
- Firstly, labour market data isn’t highlighting the underutilisation of labour and the likely rise in unemployment should lockdown measures continue to suppress economic activity.
- Additionally, structural damage in the oil industry and shifts in demand conditions are likely to weigh on business investment, dispelling the narrative of a sharp recovery by 2021H1.
- Finally, the high level of household indebtedness provides another argument for a more structural shift in consumption conditions as households prioritise deleveraging in the coming periods.
The high level of household debt-to-GDP also poses a risk of a housing market crash due to heightened loan defaults and a seizing up in credit conditions. This was highlighted by both fiscal and monetary measures which aimed to smooth the impact on Canada’s mortgage market. The Federal Government’s Insured Mortgage Purchase Program will see C$150bn insured mortgage pools purchased the Canada Mortgage and Housing Corporation, which adds to the Bank of Canada’s pledge to purchase up to C$500m per week in Canada Mortgage Bonds until no longer required.
BoC’s median expectation is that the economy won’t fully recover until 2022
UNEMPLOYMENT DATA UNDERSTATES THE IMPACT ON CANADA’S LABOUR MARKET
The latest unemployment data for April substantially underestimates the toll lockdown measures have had on Canada’s labour market. During April, the number of employed Canadians dropped 1.994m after falling 1.011m in March, pushing the unemployment rate up by 5.2 percentage points to 13% – its highest level since December 1982. The unemployment rate underestimated the true toll of the pandemic on the labour market for two reasons. Firstly, if recently unemployed workers had remained in the labour force, the unemployment rate would have risen to 17.8%. Secondly, Stats Canada reported that out of the 2m people claiming to have worked substantially lower hours, 800,000 worked no hours at all.
With a high likelihood of business insolvencies likely, further upward pressure on the unemployment rate is expected.
The wide take up of the Emergency Response Benefit scheme highlights a truer short-term measurement of the displacement in the labour market. The response benefit pays out C$2,000 per month for four months and has seen 8m applicants thus far. With the labour force standing at 20m prior to the virus, the 40% take-up of the benefit scheme is a more representative measure of the short-term impact.
THE PROJECTION OF THE ECONOMIC RECOVERY HINGES ON EXIT MEASURES AND FURTHER OUTBREAKS
While measuring the current impact of the pandemic and gauging the fiscal response is key for markets now, the recovery path for the economy ultimately depends on the speed in which lockdown measures can be rolled back. Currently, the scaling back of containment measures are being determined at a provincial level, with the Federal Government banning international travel and unessential travel to the US. British Columbia and Alberta (excluding Calgary and Brooks) are leading with their re-opening measures, while more heavily affected provinces like Ontario remain in phase 1. Thus far, on a national scale the level of re-opening focuses on essential sectors, with non-essential consumption industries limited to curbside or delivery services. The next phases of re-opening are broadly expected to occur in June, with many following the plan set out by BC and Alberta. Larger public gatherings, and a gradual re-opening of workplaces and the retail are expected, with the option for schools to resume at a specified date and likely a part-time basis.
With the economy gradually returning to normality over the coming months, growth conditions are likely to pick up and the stimulus measures take effect. However, we deem the structural scarring to Canada’s economy to be deeper than that suggested by Poloz and the headline unemployment figure, leading to a slower and more prolonged recovery.
Our expectations sit in line with the centre of the BoC projection range; that is the economy will recover by mid-to-late 2022. While assigning probabilities to the likelihood of further outbreaks is outside of our remit, the economic toll remains sizeable. For this reason we must highlight than any subsequent waves will drag on the recovery path as lockdown measures are implemented, albeit at a more concentrated level than seen in March. While in this event the economic shock will likely be met with further stimulus packages, the impact it will have on sentiment will remain a drag on the economic recovery. We expect the unemployment rate to remain close to or above 10% by year-end, while growth
FISCAL AND MONETARY RESPONSE HAS BEEN SUFFICIENT, BUT FURTHER STIMULUS MAY BE REQUIRED
The fiscal and monetary response by Canadian authorities has been sufficient at providing a level of support to the economy. The federal deficit is expected to sit comfortably in double digits for the fiscal year 2020, especially after Trudeau extended the emergency wage subsidy scheme beyond June, while we expect the Bank of Canada’s to further empty its policy tool kit. In the last MPC meeting, Carolyn Wilkins stated that the central bank’s tool kit has not been exhausted, with a funding for-lending-scheme, easing credit conditions and expanded QE still an option. With respect to further easing measures, we expect the BoC to lean on expanding its current large scale asset program from at least C$5bn while giving further forward guidance to how long this scheme would be in place. Additionally, the BoC could take a leaf out of the Federal Reserve’s book and expand its newly created corporate bond scheme to include higher-yielding debt. On the topic of negative rates, despite the communication blunder by incoming BoC Governor Tiff Macklem, we don’t expect the central bank to adjust its stance on cutting below its effective lower bound of 0.25%. The Bank are likely to keep policy at this rate, tweaking their balance sheet instead, for the remainder of the year.
Fiscal measures target direct support to households
RISKS REMAIN ELEVATED BUT AN EXTENSION IN THE CAD RALLY IS LIKELY AS THE ECONOMY CONTINUES TO OPEN UP
Despite the macroeconomic backdrop of a prolonged recovery into 2022, we revise down our USDCAD forecasts for the coming four quarters. Since our last forecast for the pair, which was made back in April, demand conditions have improved in oil markets while further monetary and fiscal stimulus has been announced globally. This has resulted in improved risk sentiment and a weakening of the US dollar from its peaks during the outbreak.
With this in mind, we expect the Canadian dollar to continue trading below the 1.40 level conditional on the current global growth path remaining supported.
However, the risks to such outlook are large and heavily skewed to the downside. With US-China tensions threatening to boil over, inducing another phase of the trade war, and the rally in oil markets reliant on OPEC+ compliance, the potential for the loonie’s recovery to meet resistance is substantial. Another prominent risk to this outlook is the resurgence in the number of coronavirus cases. Such an outcome would induce a slower recovery for the Canadian economy if it was experienced either domestically or in a major trading partner’s economy. Notwithstanding these risks, however, with the Canadian economy beginning to open back up again we believe USDCAD will continue trading towards the 1.35 level by year-end.
Author: Simon Harvey, FX Market Analyst