The volatile dollar: the road ahead
Diverging monetary policy trends and asymmetric growth prospects suggest that the recent, wide swings in the USDCAD exchange rate are likely to continue in the second half of the year.
Global Foreign Exchange,
Global Foreign Exchange,
A simple, but relevant, truism for the USDCAD outlook is that volatility is back. Last year saw a net gain in the USD of a little more than 19% against the CAD.
Only the exceptional market volatility seen around the 2008 financial crisis has produced a bigger (+22%) swing higher or lower in the USD over the course of the year (open to close) against the CAD.
The post-crisis environment saw broader market volatility smothered by the extraordinary and aggressive monetary-easing steps of the US Federal Reserve (Fed).
With the Fed now moving slowly towards policy normalization, we expect tighter US monetary policy to foster not only a stronger USD but also a more volatile environment in the global currency space broadly as investors look for trading opportunities based around asymmetric growth prospects and central-bank policy priorities that diverge with the Fed.
The more recent twists and turns in the USDCAD exchange rate reflect the return to more volatile market conditions (the annual range traded by USDCAD has risen every year since 2011/12).
The CAD hit a 12-year low against the USD in January, pressured by the sharp decline in oil prices and the resulting terms-of-trade shock this imposed on the Canadian economy.
Two key areas the Bank of Canada (BoC) hoped would do more heavy lifting for growth – business investment and the trade sector – struggled. Short-term interest rates fell as market participants speculated that the BoC would ease policy to provide support for the economy, further pressuring the CAD.
The headwinds pressuring the CAD eased as the first quarter unfolded (as did the tailwinds supporting the USD), laying the groundwork for an impressive reversal in the USDCAD trend.
The near-doubling in the price of crude oil from the Q1 sub-US$30 lows was also a major source of support for the CAD recovery through Q1. While Canadian interest rates recovered, US interest rates fell. The Fed balked at tightening interest-rate policy in March as US data suggested weaker-than-expected growth trends in Q1.
On the one hand, Canadian economic data reports came in better than expected for much of the early part of the year. A new Federal government in Ottawa and the prospect of a fiscally stimulative budget suggested improved Canadian growth trends moving forward (and reduced pressure on the BoC to ease).
Recent developments suggest another significant twist in the USDCAD trend is unfolding. The massive wildfires in Alberta have clipped back Canadian growth prospects again, though perhaps only temporarily (Q2 growth will be weak, but we expect a recovery in Q3).
Meanwhile, a record trade deficit for Canada in March suggests a key component of the economy is still not firing on all cylinders. A further weakening in Canada’s external account position would be an additional, possibly material, burden for the CAD in the medium-term, we believe.
Oil prices settling into a trading range around US$50/bbl are less obvious a support for the CAD at this point, we believe.
Meanwhile, the US economy appears to be rebounding from the Q1 softness and Fed policymakers are actively encouraging a recalcitrant market to recognize the risk of US interest-rate policy tightening over the second half of the year.
With hardly one rate increase fully factored in to the US yield curve currently, the prospect of two – or more – rate increases from here would force a significant re-pricing of short-term interest rates and provide additional support to the USD.
For the CAD, the balance of risks appears tilted to the downside through the mid-year period as market participants consider the deterioration in domestic fundamentals and renewed divergence in the BoC-Fed policy outlook.
We expect further CAD weakness on the back of a continued widening in short-term US-Canada yield differentials.
We have maintained a year-end 2016 forecast for USDCAD of 1.30 throughout the recent volatility in the exchange rate, assuming modest gains in crude oil prices and better economic data supporting prospects for the BoC to lift interest rates in 2017.
However, some of the challenges facing the CAD noted above may prove to be persistent and more aggressive than currently expected (by the market) while Fed tightening moves will add to positive USD momentum broadly.
The CAD may underperform somewhat relative to our current forecast. If we have any conviction at all, it is that volatility and uncertainty will rise, meaning that investors and corporate FX hedgers cannot afford to be complacent about the currency outlook over the balance of the year.
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