Canadian Dollar Facing Headwinds Following Blistering Start to 2016

The outlook for the Canadian dollar depends on whether or not the economy can repeat the outstanding performance witnessed at the start of 2016.

• The pound is forecast to fall over coming months with a low seen at GBP/CAD 1.51
• The USD/CAD is expected to recover over coming months based on RBC Capital’s research

Canada’s economy jumped out of the starting gates in 2016 with a 0.6% increase in GDP reported in January that doubled market expectations for the month.

The increase was broad based but led by strong growth in manufacturing and transportation & warehousing, both of which benefitted from strengthening exports.

“With solid gains also recorded in November and December, the economy has grown at a 5% annualised pace in the last three months for which data are available, the strongest streak since 2013,” notes Josh Nye, an economist with RBC Capital Markets.

The strong economic performance played a large part in the Canadian dollar’s outlandish ascent:

The US dollar to Canadian dollar exchange rate has fallen dramatically with one US dollar buying as much as 1.4690 Canadian dollar’s in January whereas the achievement of only 1.2989 is possible now.

Of course these rates are based on the spot markets; once banks apply a spread anything between 1.26 to 1.2528 being achievable on your international payments.

The equation is more favourable however if specialist providers are considered with rates between 1.2865 and 1.2774 being achieved.

Headwinds to the Economy Could Spoil the Party

The question most readers will be asking is whether the Canadian dollar can continue to deliver further strong gains.

While the dynamics of the oil market are of course incredibly important to the Canadian dollar’s outlook, so too is the performance of the economy.

Much of the recent pickup in Canadian growth has been tied to stronger export performance.

We had assumed net trade would be an important offset to declines in the energy sector as a strong US economy (benefitting from lower oil prices) and Canadian dollar depreciation (also oil-related) were forecasted to boost exports.

While it is hard not to be encouraged by the recent performance in growth and trade, the Bank of Canada’s Business Outlook Survey provided a good reminder of the headwinds that continue to face Canada’s economy.

The Bank of Canada notes:

“Firms’ perspectives continue to diverge sharply, depending on whether they are tied to the commodity sector and on their exposure to foreign demand. Expectations for future sales growth remain positive, with clear signs of support from U.S. demand. Yet the outlook for domestic sales is guarded in light of sluggish demand and the ongoing adjustment to lower oil prices.”

Furthermore, on the employment front:

“Investment and employment intentions have increased but remain modest, with balances of opinion masking a sharp split among firms.”

RBC Capital’s Nye warns that there is a risk that recent currency appreciation will provide less of a boost to net exports in the medium term while the modest increase in oil prices is not enough to spur a rebound in energy sector investment.

The picture we are therefore getting is that the Canadian dollar will be unable to rely on the strong economic surprises that we have seen over recent months.

Indeed, any disappointments could see the CAD punished.

Question Marks Over Whether the Government Can Deliver Promised Growth

A big input into Canadian growth dynamics remains the willingness of the new government to spend.

The federal government’s March 22 budget was largely as expected with annual deficits of around $29 billion projected in each of the next two years in a sign that pumping money into the economy is being prioritised over fiscal prudence.

The Department of Finance estimated new spending measures, most significantly infrastructure investment and transfers to households under a new child care benefit, would boost real GDP growth by 0.5 percentage points in both fiscal years 2016–17 and 2017–18.

“However, given the optimistic multipliers used in those estimates and the timing of stimulus in calendar year 2016, we have retained our more conservative estimate of a 0.2 percentage point add to 2016 growth, with a similar-sized boost expected in 2017,” says RBC's Nye.

Why This Matters for the Canadian Dollar

The government’s willingness to spend, and the impact it has on economic growth, is relevant to the Canadian dollar via the decision making at the Bank of Canada.

The Bank of Canada’s manipulation of interest rates in response to economic conditions has the side effect of stimulating or discouraging demand for the currency.

Higher interest rates typically invite a stronger currency, while the opposite is true for declining rates.

“Stronger growth in 2016 and continued support from fiscal stimulus in 2017, however, should increase the Bank’s confidence that the output gap will be closed next year,” says Nye.

If the Bank is growing in confidence then the prospect of further CAD-negative interest rate cuts are likely to decrease. Indeed, we could even start talking about higher Canadian interest rates over coming months.

“We expect the BoC will remain on the sidelines in 2016, holding the overnight rate steady at 0.50% before beginning to tighten policy next year,” says Nye.

Given RBC Capital’s forecast for a protracted tightening cycle from the Fed, they now expect the BoC will raise rates gradually next year with the overnight rate expected to end 2017 at 1.25% rather than the 1.75% they previously assumed.

Forecasts for the Currency

RBC Capital are forecasting the USD to CAD exchange rate to rise to 1.33 by mid-2016 ahead of a peak of 1.36 towards September.

The rate is forecast to settle back to 1.33 by the end of the year before falling below 1.30 in 2017.

Against the pound, the currency is forecast to strengthen with the GBP to CAD exchange rate falling from 1.56 in mid-year to 1.54 in September.

The rate will remain around here into year end before falling further to 1.51 at the start of 2017.