Bank Of Canada Lifts Loonie Offsetting Dull Outlook For Oil

The fortunes of the Canadian dollar have changed quite drastically since May. While USD/CAD was lingering near 1.37 just a couple of months ago, it is now in position to test purchasing power parity (PPP) levels of 1.24.

A rapid change of policy stance from the Bank of Canada coupled with a dovish sounding Fed fuelled the loonie’s ascent. The central bank’s decision to raise the overnight rate by 25 basis points in July to 0.75% (its first rate hike in seven years) was backed by a more optimistic take on the economy. Indeed, the BoC raised its 2017 real GDP growth forecast for Canada from 2.6% to 2.8% ─ the central bank expects a solid follow-up to the strong first half ─ something it says will close the output gap by year end, two full quarters sooner than what it had estimated back in April.

More favourable yield differentials pushed up the loonie but so did speculators who chopped their short positions in half in just a few weeks. The last time we saw such a reversal in speculative short positions was back in 2012. Those factors allowed the loonie to gain altitude despite headwinds from depressed oil prices.

Indeed, saddled with a supply glut, the price of WTI oil remains below $50/barrel. Saudi Arabia’s efforts to boost world oil prices via output cuts are not having the intended impacts because non-OPEC oil producers are offsetting those cuts with increased production of their own. U.S. oil output jumped to a 2-year high of 9.4 million barrels/day in July, according to the Energy Information Administration. Shale production, which fell sharply in 2015/16 in the aftermath of the oil price slump, is now bouncing back. U.S. shale producers have been able to find efficiencies and cut their production costs in half in just three years, allowing them to be profitable even at currently low prices. Worse for the Saudis is their waning influence even within OPEC. The deterioration in relations between the Saudis and Qatar is unlikely to help. Iran, which made clear it will not participate in OPEC’s output reductions, has pushed its output to a nine-year high. As such, we believe the oil supply glut is unlikely to be absorbed anytime soon.

But as we’ve seen in recent weeks, the persistence of soft oil prices does not preclude Canadian dollar appreciation. Momentum could allow for further near term dollar gains, more so if speculators continue to cut their short positions. But given the recent surge, we’re now less upbeat about the loonie’s longer term prospects. Inflation remains stubbornly low and below the Bank of Canada’s 2% target. The central bank said it is confident inflation will return to 2% in 2018, blaming currently low inflation on temporary factors and “the lag between monetary policy actions and future inflation.” But it also acknowledged some risks to that forecast, saying that the slowdown in inflation of some advanced economies (including Canada) may be due to “common factors,” such as downward trend in inflation expectations. That would be a motivation for being cautious with rate hikes. So, while we wouldn’t be surprised to see further Canadian dollar gains over the near term, we expect a giveback afterwards as the USD makes a comeback with markets starting to price Fed rate hikes. We continue to expect USD/CAD to remain in the 1.25-1.35 trading range over the next 12 months.

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For now, markets remain very skeptical the Fed can deliver the rate hikes it says it expects. Who can blame them, particularly after Fed Chair Janet Yellen’s recent testimony in front of Congress? While the chair expressed confidence inflation will move back up to target, she admitted there were more than just temporary factors that are keeping inflation low. Yellen also added that the fed funds rate would not have to rise very much to get to a neutral stance.

The Fed chair reiterated that the FOMC planned to proceed with gradual interest rate increases in the coming years and is likely to start shrinking its $4.5-trillion balance sheet “relatively soon.” But no decisions have been made regarding the sequencing of actions. Based on that statement, one could argue that the FOMC will announce the beginning of the reduction in the balance sheet before a next rate hike. If, as we expect, U.S. GDP growth picks up next year ─ courtesy of fiscal stimulus being dispatched before the 2018 mid-term elections ─ the Fed may surprise markets with a combination of rate hikes and balance sheet reduction. As such, the trade-weighted USD could bounce back next year.

The Eurozone had a better first half of 2017 than many (including us) expected. Growth has picked up and employment is now at all-time highs, having recovered all the ground lost during the recession. Economic sentiment is also the best in a decade. With all those tailwinds, why then is EUR/USD stuck near 1.14? Old problems may be restraining the common currency. Reforms have stalled and economic growth, while improving overall, is not broad-based, as evidenced by continuing struggles in southern Europe. Uncertainties with regards to Brexit and next year’s elections in Italy ─ the latter’s economic weakness puts incumbent Prime Minister Paolo Gentiloni at risk of falling to anti-EU populists ─ also cast a shadow over the eurozone. Persistently low inflation also cast doubts about the European Central Bank’s abilities to withdraw policy stimulus. As such, we do not see a lot of upside for EURUSD from current levels over the forecast horizon, more so considering the massive amounts of speculative long positions on the common currency.

Written By: The National Bank of Canada