In our last USDCAD update in Q2, we projected an extension in the loonie’s rally after it broke out of its post-pandemic range at the end of May, while also highlighting some of the risks to the rally over the coming months. The directional call proved to be right but we didn’t anticipate the broad swathe of dollar weakness that ripped up the FX markets forecasts in July and early August.
While the risks outlined in our Q2 report meant that the Canadian dollar lagged the wider G10 rally, with the loonie’s move more concentrated in the month of August as opposed to July like the rest of the G10, the period of USD weakness meant that our previous point forecasts are now overly bearish.
The point forecasts have since been adjusted accordingly and retain our view of an extension in the CAD rally over the 12-month horizon.
We also believe that the rally will face increased risks as the USDCAD rate approaches the 1.30 level and tests the Bank of Canada’s tolerance level. The upcoming “recuperation” period also poses risks to our bullish stance on the loonie as the economic recovery naturally slows and governmental support measures are scaled back. Additionally, with flu season just around the corner as the fall and winter months approach, the possibility of localised lockdown measures has edged up, while heightened fiscal and political risk mustn’t be ignored ahead of Parliament’s return. With the above risks in mind, both the loonie’s rally and the economic recovery are set for a bumpier ride in the next few quarters as the headwinds start to set in.
Latest forecasts supplied to Reuters as of 1st September 2020:
ECONOMIC RECOVERY EXCEEDS BANK OF CANADA’S EXPECTATIONS BUT IT’S ABOUT TO FACE ITS FIRST MAJOR TEST
Economic data thus far has exceeded the Bank of Canada’s expectations during the early part of the recovery phase. This was best highlighted by Q2’s GDP reading, which came in at -38.7% in annualised terms compared to the -44% expected in the BoC’s July Monetary Policy Report. The GDP beat was largely due to the impact of easing lockdown measures towards the end of the quarter, which helped record a 6.5% MoM reading for June and a 3% preliminary reading for July. Including July’s preliminary data, this now places gross domestic product some 6% below February’s levels. The labour market has also showed signs of optimism with employment sitting only 1.1m workers shy of where it was in February. While this may still sound like a substantial level of labour market slack, it is far better than the 3m person rise in unemployment due to the pandemic, which increases further to 5.5m once accounting for Covid-related absences. Related absences fell to just 713,000 in August, while employment gains re-centered on full-time jobs as opposed to part-time employment. This had the spill-over effect of reducing the underemployed rate by 259,000 workers. Additional positives can be found in the fact that these labour market statistics are being compared to February’s level where employment was at record highs. Relative to a five-year moving average, the labour market is much closer to recovering than the data suggests when compared to February.
Net level of employment close to returning to 5-year moving average, but remains someway off of February’s record setting level
Naturally, the recovery will start to slow as the initial bounceback and release of pent-up demand starts to fade. The Bank of Canada has rightly highlighted this and labelled the next part of the recovery the “recuperation” phase, where growth is expected to be “slow and choppy”. But on top of this natural slowdown, the economic recovery will be tested by the removal of fiscal support and the elevated possibility of localised lockdown measures. In the second quarter, government transfers rose 88% on a non-annualised basis, but this level of fiscal support isn’t sustainable, as highlighted recently by Fitch ratings. Fiscal support measures are, therefore, set to expire as the federal budget deficit approaches 16%. The most notable support measure being removed is the Canada Economic Response Benefit on September 27th. While the C$500 weekly payment programme is scheduled to be replaced by other labour market support measures – such as Employment Insurance or the new suite of temporary recovery benefits aimed at gig, contract and care workers – the average payout of these replacements will only be C$375 pre-tax on average, as reported by the Canadian Centre for Policy Alternatives. The CCPA also estimate that some 482,000 former CERB recipients won’t be applicable for the alternative schemes, which will further weigh on the consumption recovery.
As the fiscal support measures are scaled back, the underlying structural damage will become more visible.
Bank of Canada Governor Tiff Macklem highlighted this in his latest appearance, stating that the structural shift in the economy is unknown and will pose a risk to the recovery as businesses try to navigate this new economic climate. With the CERB scheme tailing off at the end of the month, the emphasis will now be on the Canadian Economic Wage Subsidy scheme to do the heavy lifting. The CEWS scheme subsidises up to 75% of the employers wage bill for returning workers, conditional on business’ revenue dropping at least 30% due to the pandemic. Some C$35.31bn has already been paid out through this scheme as of September 13th, with the CEWS scheme set to expire on November 21st. At the end of the year, as these two major labour market support measures are withdrawn, the true level of scarring induced by the pandemic will be visible in December’s jobs data.
The reduction in labour market support poses the largest risk via the housing market. While house prices have been soaring in Canada yet again, much of this is due to pent-up demand. As this flushes through the system and the governments labour market safety net begins to vanish, the choppy period of growth over the coming quarters will likely ripple through the housing market, dampening price growth. In addition to this, six-month mortgage deferrals brought about due to the pandemic are set to expire in late fall, unless the deferrals were rolled for 3-months during the August 30th – September 30th window. Around 2.6m Canadians (around 9% of credit consumers) have at least one active deferral, with 28% of those deferrals being mortgages according to TransUnion Canada. While anecdotal evidence from Bank executives suggests they aren’t concerned about mortgage defaults rising, much of the analysis on repayments has occurred during a time in which the labour market support measures were in full swing. Once these are removed and the business climate starts to count the cost of the pandemic, the number of mortgages in arrears, both consumer and commercial, and thus subject to default are likely to climb and weigh on house price growth. However, this won’t be a quick dynamic as large banks have implemented payment plans for at risk mortgages and those opting for mortgage deferrals. The Bank of Canada itself said it expects the number of mortgages in arrears to peak in Q2 2021, more than doubling the current rate of 0.24%.
Number of mortgages in arrears set to spike in Q2 2021 as supports measures are removed, but the level of uncertainty around this projection is elevated
Source: Bank of Canada
QUANTITATIVE EASING TO BE THE MAIN MONETARY TOOL IN THE NEXT TWO QUARTERS AS THE ECONOMY ENTERS THE “RECUPERATION” PHASE
The message from the Bank of Canada was delivered loud and clear by Governor Tiff Macklem when he spoke to the Canadian Chamber of Commerce on Thursday 10th September. That is, the BoC’s balance sheet will play a more active role as the economic recovery slows and becomes choppy with the winter months approaching.
This part of the recovery, labelled the “recuperation” phase, is not only a by-product of the incoming cold weather and the increased likelihood of localised measures being imposed, but also the natural progression of the rebound as the impact of Q2’s pent-up demand is flushed through the economy.
This announcement by Governor Macklem was broadly expected as the BoC’s balance sheet started to plateau in the weeks prior to the latest policy decision. This was due to the Bank deciding that liquidity conditions were sufficient in the Treasury bill market to start tapering their purchases from 40% to 20% at auction, ultimately leading to previous purchases rolling off of the balance sheet at maturation. This offset the BoC’s Government of Canada bond purchases, which are set at a minimum of C$5bn a week and led to a flattening of the balance sheet. Despite this dynamic being pinned to liquidity conditions, it is also a move that maintains space on the Bank’s balance sheet to ramp up the QE programme should the recovery start to stall and economic frailties come to the fore. This conservative approach leading into the period of choppy growth highlights that the BoC is concerned about saturating bond markets should conditions deteriorate, owing to the fact that its QE programme will be the first line of defence. As recently as the 15th of September, the BoC announced that it would further reduce its purchases of T-bills from 20% to 10%, again citing improved liquidity conditions.
The main chart in focus over the coming months is the BoC’s balance sheet as QE is defined as the marginal policy tool to support the economy
The recent winding down of Mortgage Backed Securities purchases also highlights this conservative approach by the BoC heading into this recuperation phase. Elevated household debt-to-GDP will be at the forefront of the Governing Council’s mind heading into the fall months, for the aforementioned reasons. The Bank has wound down its MBS purchases back towards the minimum C$500m per week as house prices continue to grow, but with the outlook riddled with uncertainty, the BoC may quickly ramp up its MBS purchases should mortgage delinquencies start to rise and house prices begin to falter.
Macklem also highlighted the strength of the loonie as a potential headwind for the Canadian economic recovery. A stronger currency not only reduces inflation through the imports channel, but also makes exports less competitive, weighing on growth.
With USDCAD trading above the 1.30 level, we don’t expect the Bank of Canada to verbally intervene in FX markets, as has been seen from the Reserve Bank of New Zealand and the European Central Bank lately.
However, similar to the verbal intervention conducted by former Governor Poloz back in October 2019 and January 2020 meetings, Governor Macklem could start weigh in on the topic further should USD weakness push the USDCAD rate below 1.30. The threat of ramping up its QE programme further will be a credible downside risk for FX markets during the early part of the recovery.
FOR THE LOONIE, WITH ALL OF THE AFOREMENTIONED RISKS TO THE ECONOMIC RECOVERY ON THE HORIZON, THE BIGGEST NEAR-TERM DRIVER WILL UNDOUBTEDLY COME FROM MONETARY POLICY DIVERGENCE
The Federal Reserve’s latest pivot towards an average inflation target has weighed on the dollar as markets begin to price looser monetary policy for longer from the Fed. The latest decision by the Fed to keep real rates in negative territory until 2023 by current estimates initially led to a bounceback in the dollar. However, as the recoveries begin to mature, we expect the dollar to come under increasing pressure as the Fed’s reaction function is less sensitive to an inflationary overshoot. However, in the interim, little forward guidance has been given over both the Fed’s and the BoC’s QE programmes, but befitting with the US central bank’s pivot towards looser monetary policy for longer, we expect the threshold for normalisation in this regard to be lower for the BoC. In the coming months, focus on both central banks will remain on the levels of forward guidance, with the BoC expected to define what “recovery well underway” really means in practice.
Questions around the BoC following the Fed’s path towards an average inflation target are premature in our opinion. Consumer inflation expectations outlined in the Bank’s Survey of Canadian Consumer Expectations are well anchored above the 2% target at 2.8% for one year ahead, while market breakeven rates have recovered well back towards target. Given that the pivot in the Fed’s inflation framework was driven by falling inflation expectations, we don’t expect the BoC to follow suit anytime soon. This was highlighted by Macklem who recently stated that the BoC’s own framework review, which isn’t due to conclude until 2021, hasn’t revealed any clear alternatives to the current framework.
Breakeven inflation rates have recovered back to back above of the BoC’s lower bound
In addition to the above risks to our USDCAD projections, the path of fiscal policy and political uncertainty will also play an integral part in upcoming price action
Fitch ratings recently warned Canada that fiscal consolidation will become more challenging should the Government not put in place new debt targets to try and tilt the debt-to-GDP onto a downwards path over the medium-term. At present, gross government debt-to-GDP is expected to rise above 120% in FY20/21, which Fitch warns is “significantly higher than the ‘AA’ median” where Canada currently places with an AA+ rating. Additionally, Canadian Bank chiefs have warned the Trudeau government that some indication of deficit caps will be needed to improve accountability for the Government’s deficit spending and control the spiraling level debt. With all of this in mind, Prime Minister Trudeau and new Finance Minister Chrystia Freeland are expected to unveil an ambitious spending plan at next week’s parliamentary address on the 23rd September. Freeland has recently reiterated that despite Prime Minister Trudeau pledging deficit spending for some years to come, the government will retain prudence and sound fiscal management.
While fiscal policy has played a far more active role in the economic recovery relative to previous recessions, there is a thin line in FX markets reaction function when it comes to fiscal policy being cyclically positive and structurally negative.
Potentially looming credit downgrades may tip the balance towards structurally negative should the Trudeau administration not step cautiously with its new growth plan. The resumption of Parliament will end Trudeau’s carte blanche when it comes to spending next week, as the minority government’s fiscal actions will be held more accountable in order for them to pass the legislature. While this is a positive for the loonie as it limits the possibility of FX markets focusing on the negative consequences of elevated debt levels, a further risk comes in the form of a snap election. With Parliament set to resume next week, the government will face a vote of no confidence, which is usually a formality after being prorogued. However, the rival Conservative party has a new leader in the form of Erin O’Toole, who could make life difficult for incumbent Justin Trudeau in order to mark his arrival. The resumption of Parliament also means select committees will resume their investigation into links between Trudeau and former Finance Minister Bill Morneau and WE charity.
DESPITE THE RISKS, MONETARY POLICY DIVERGENCE AND MORE ACCOUNTABLE FISCAL STIMULUS HOLDS CAD IN STRONG STEAD TO CONTINUE ITS RALLY
On the whole, we expect monetary policy divergence to provide the main source of stimulus for a mild extension in the CAD rally, while more accountable and active fiscal policy measures are likely to drive a stronger than expected recovery. However, despite the forecasts suggest a smooth downwards path for USDCAD over the 12-month horizon, this is the last thing we expect. With so many factors in play, along with the likelihood of intervention by the BoC once USDCAD breaches the 1.30 level and the upcoming US Federal election in November, the loonie’s rally is likely to face increasing resistance and heightened volatility throughout the early parts of the recuperation phase.
Author: Simon Harvey, FX Market Analyst