'CADapult': Buy USD/CAD targeting 1.40 - Deutsche Bank

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Deutsche Bank on the Canadian dollar

USD/CAD is set to rise above 1.40 over the course of 2017, predominantly driven by faster-than-priced Fed tightening and US tax reform. A possible US border tax adjustment would boost the broad USD and have a disproportionately negative impact on Canada's growth by reducing investments and exports, unless offset by depreciation.

Domestically, expectations of Bank of Canada tightening are unlikely to pick up before H2 as the positive output gap and macro-prudential measures in the housing market continue to keep inflation well below target.

Finally, even with higher oil prices, the Canadian dollar should continue to be pressured lower by a persistently deteriorating external position.

Monetary policy divergence kicking in hard and fast Starting in Canada, we expect the BOC to hike rates only once toward the end of 2017 as the output gap closes. There is considerable uncertainty as to the timing of a first BOC rate hike, largely because of disparate views on the level of potential growth. The Bank of Canada estimates it at 1.75%, but we estimate the range to be as wide as 1.4 - 2.9%, using the Bank's own models (chart 1). Inflation tends to pick up only when growth moves close to the upper-bound estimate of potential growth. This is very unlikely to happen in the first half of the year given macro-prudential measures taken to cool down the over-heated housing market. These measures, in our view, are largely responsible for the BoC's forecast of a 30bps decline in core inflation in 2017 given that shelter and household operations account for 40% of the CPI basket. In contrast, we expect the Fed to tighten at a faster pace than is priced by the market, and especially so as we head into 2018, by which time fiscal stimulus is likely to have kicked in fully.

Based on regressions, USD/CAD would rise to between 1.37 and 1.43 based on consensus interest rate two year forecasts, assuming that the other key driver, oil, remains constant (chart 2). Regressions also suggest that a surprise Fed hike in Q1 could propel USD/CAD by up to five cents, from levels that already look slightly cheap against the current two-year nominal rate spread (chart 3). To be sure, the impact of a faster-than-priced Fed hiking cycle would likely be lower than a regression suggests because it would likely be prompted by a faster-growing US economy, with positive ramifications for Canadian exports. Nonetheless, the simple beta underscores the extent of the upside potential should the Fed surprise on the hawkish side this year.


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