By Jonathan Patner
What will it take for the loonie to make a comeback?
The Bank of Canada was the first central bank to turn in a more dovish direction this summer, and it continued to maintain a cautious tone following the year’s second interest rate hike in September. However, impressive employment numbers for the month of October (released on Friday) have helped alter the rate outlook, and that’s prompted J.P. Morgan to tell clients to buy the Canadian dollar.
Noting that the currency market is discounting two rate hikes by the BoC in 2018, the bank’s head of FX, John Normand, sees upside potential for longer-term rates. That comes as more evidence emerges that labour slack is not as great as the BoC believes.
His long recommendation for the Canadian dollar (versus the Swiss franc) is “not so much because it’s lagging oil, rather that faster wage growth could give a renewed hawkish nudge to the BoC.”
The loonie had its biggest monthly decline of the year in October, despite the rally in oil prices.
On Monday, WTI crude broke above the US$56 per barrel market for the first time since the summer of 2015, yet the commodity’s link to the loonie has been waning since June. Oil’s correlation with the Canadian dollar recently hit its lowest level in nearly three years, although further gains for crude could provide some support for the loonie.
“BoC and ECB have been at the vanguard of reshaping non-US rate expectations this year, and their easing up on policy normalization rhetoric in October sparked good-sized spot swings in the immediate aftermath of meetings,” Normand said.
“(Friday’s) labour data should provide some renewed impetus to the tightening cycle,” he added, noting that Canadian wage growth moved up to 2.4 per cent on an annual basis, compared to 0.7 per cent only six months ago.
J.P. Morgan’s new recommendation to capitalize on recent weakness in the Canadian dollar by trading it against the Swiss currency, is partly due to an effort to avoid shorting the U.S. dollar. Normand believes the momentum in U.S. growth and growth expectations should at least allow the greenback to consolidate.
He doesn’t recommend adding to existing Japanese yen shorts either, because of the possibility of trade tensions heating up during U.S. President Donald Trump’s Asian tour.
“Trade tensions will continue to deliver volatility more than trend,” Normand said. “Last month’s drama over NAFTA was a both a reminder that U.S. trade policy remains a serious risk that can deliver sudden volatility and thus cannot be ignored, but at the same time is not a persistent enough risk to drive the trend in FX.”
He noted that the near-term prospects for the U.S. dollar to continue its rally have faded somewhat with Jerome Powell being nominated as Fed chair, the House tax reform bill not challenging expectations for fiscal stimulus, and wage growth weakening. Yet J.P. Morgan isn’t all that concerned about the U.S. dollar rolling over given the constructive environment for growth.
“…Trump policy initiatives are producing more noise than impact, and thus more near-term volatility than medium-term trend,” Normand said.
Douglas Porter, chief economist at BMO Capital Markets, believes the case for higher rates is much less compelling in Canada than in the U.S. However, he believes the Canadian rate story will gradually re-emerge in 2018.
“Until then, the Canadian dollar will be partly shackled by this temporary divergence in rate hike prospects as well as by NAFTA uncertainty, which looks to stick around for some time yet,” Porter said.
Interest rate spreads with the U.S. have become unfavourable for the Canadian dollar, largely because of the BoC’s dovish tone. The central bank is now sending the message that the Canadian economy is more sensitive to interest rates, so future rate hikes will need to come slowly.
“That’s a bit like saying it will keep feeding the beast it created after years of ultra-loose policy – overleveraging and housing taking a disproportionate share of the economy – for fear of being bitten,” said Stéfane Marion and Krishen Rangasamy, economists at National Bank Financial.
They have pushed back their forecast for the next Canadian rate hike to early 2018, but still believe strong data will force the BoC to deliver more rate hikes next year than what the market anticipates.
“If we’re right, then expect the Canadian dollar to make a comeback early next year,” the economists said.
Source: Financial Post