CBA FX Strategy
Global Markets Research
19 March 2014
CAD: the flightless loonie
Dovish BoC rhetoric, a patchy Canadian economy, reduced capital inflows & limited yield support are weighing on CAD.
CAD weakness should continue in the near-term. The expected bounce back in the USD should boost USD/CAD further.
AUD/CAD reached our published target. The fundamental drivers for further near-term gains in AUD/CAD remain.
NZD/CAD is nearing its post-float high. A hawkish RBNZ & high NZ terms of trade suggest the high could be tested.
CAD weakness to persist?
The underperformance in the CAD continues to be a theme in FX markets. On a trade-weighted basis, the CAD has declined by 4.1% since the turn of the year. In our view, CAD weakness has further room to run. There are a number of factors that should continue to dampen the CAD over coming months:
Dovish Bank of Canada. It is hard to deny that the underlying tone of the Bank of Canada (BoC) has turned more dovish since new Governor Poloz took the helm in mid-2013. In late January, the BoC Governor acknowledged that the door was “slightly more open” to a rate cut. In a press-conference on 18 March (19 March AEDT), Governor Poloz added that he “can’t rule out interest rate cuts at this point”. While the delivery of a rate cut by the BoC would need a sustained deterioration in the Canadian economic growth and/or inflation outlook, the prospect of rate hikes remain very distant. We think the BoC will remain on hold at 1% until Q4 2015. In addition to the outlook for rates, the BoC continues to jawbone the CAD lower. A lower CAD would help the Canadian economy rebalance away from household spending towards business investment and exports. Significantly in his most recent comments, Governor Poloz stated that there were “few signs” the Canadian economy (specifically exports) was reacting to the fall in the CAD. And that the decision to leave out a reference to the CAD in the March post meeting statement should not be interpreted as a signal the BoC was comfortable with the level.
Limited front-end yield support. Canadian two-year bond yields have drifted back down to 1%. The dovish tilt by the BoC and softness in the Canadian economic data should weigh on front-end Canadian bond yields for some time.
Reduced capital inflows. Between 2009 and 2012, significant capital inflows into Canadian debt instruments helped support the CAD. The rate of these inflows has decelerated sharply over the past year, and indeed net outflows were recorded in 5 of the 8 months to January 2014.
(4) Softer Canadian growth pulse. Although Canadian GDP growth was stronger than expected in Q4 2013, printing at 2.9%saar, the detail was far from impressive. An increase in inventories contributed nearly half of the growth in the quarter. Q4 2013 growth in final domestic demand, which takes out international trade and inventories, was at its slowest since Q1 2009. Should the stock rebuilding witnessed in Q4 2013 be unintended, inventories could well be a drag on growth in Q1 2014. This would compound the already expected slowdown. Governor Poloz stated that due to harsh weather, Q1 2014 growth is set to be “on the soft side”.
The relatively subdued growth pulse should keep the Canadian labour market under pressure. Annual employment growth in Canada has slowed to just 0.5%. This is well below its long-term average of 1.3%pa. This suggests the bias is for the Canadian unemployment rate, currently 7%, to continue to rise over 2014. The soft underbelly of the Canadian labour market and spare capacity in the Canadian economy should keep inflationary pressures muted and near the bottom of the BoC’s 1-3% target band for some time.
USD/CAD, AUD/CAD & NZD/CAD
As outlined above, we think there are various factors that should continue to weigh on the CAD. The fundamental factors weighing on the CAD continue to contrast the outlooks for a number of other currencies.
In addition to the CAD side of the equation, we expect the USD to rebound from its recent slump and grind up over 2014. The recent decline in the USD stems largely from the weather-induced weakness in the US data and increased FX reserve re-cycling by global central banks Over coming months, as the weather impact rolls out of calculations, we expect the positive underlying medium-term trend in the US economy to reassert itself and for the US data to improve. A pick up in the US data, in combination with the US Fed’s ongoing monetary policy normalization and positive US-G6 weighted two-year swap spread, should guide the USD higher over the medium-term (chart 5). We forecast USD/CAD to rise to 1.1800 by 2014 year-end. A less negative US-Canada two-year yield spread, driven by factors on both sides of the equation, should help guide USD/CAD higher over 2014.
The diverging perceptions regarding the outlook for Reserve Bank of Australia (RBA) and BoC monetary policy and a wider Australia-Canada two-year yield spread helped AUD/CAD reach our published target of 1.0125 on 19 March. The factors previously highlighted remain in place and suggest further gains in AUD/CAD are possible. In contrast to the BoC, the RBA commentary continues to stress a “neutral” policy bias. Indeed, in its more recent commentary, specifically the minutes of the March Board meeting, the RBA noted that: (a) the “timely indicators were consistent with some improvement in economic conditions over recent months”; and (b) there were “further signs that low interest rates were providing support to activity”. We think the RBA is at
the low point of the cycle. We expect the first RBA rate hike to be in Q4 2014. Over the coming months, if the data improves and the transition away from mining investment-led growth in Australian occurs broadly in line with our expectations, there appears to be plenty of room for market expectations for RBA rate hikes to be pulled forward. Currently the market is expecting the first RBA rate hike to be in mid-2015. This would support front-end Australian bond yields and keep the Australia-Canada two-year yield spread firmly in Australia’s favour. This would keep AUD/CAD firm. Based on these developments, we see upside risks to our current AUD/CAD forecasts, particularly in the near-term.
At the time of writing NZD/CAD is less than 3% away from its post float high (0.9859) set in March 1997. In our view, there is a high chance NZD/CAD sets a new post-float high over coming months. We see upside risks to our NZD/CAD forecasts. The contrasts between the respective drivers of the NZD and CAD continue to broaden. More specifically, while the BoC remains on hold and continues to highlight the risk of a rate cut, the RBNZ has commenced its tightening cycle. In March, the RBNZ raised the cash rate by 25bpts to 2.75% and presented a slightly more hawkish than expected outlook. The RBNZ front-loaded and lifted their 90-day forecast track, implying a more assertive normalisation of policy. The RBNZ also extended their forecasts out to March 2017 (normally two-years). The new track showed a tightening of policy well past the 4.5% neutral rate, to 5.25% by March 2017. Our New Zealand economists expect the RBNZ to follow up its March rate hike with another 25bpt hike in April and two more 25bpt rate hikes in H2 2014. Further RBNZ policy tightening and greater positive momentum in the New Zealand economy relative to the Canadian economy should keep the New Zealand-Canada three-year swap spread elevated. This should keep NZD/CAD buoyant. In addition, unlike the BoC, the RBNZ does not appear to be looking to aggressively talk-down the NZD. Although RBNZ Governor Wheeler noted that the high exchange rate is a headwind for the New Zealand economy at the March policy meeting, the RBNZ’s expectation of an extremely high terms of trade over the forecast horizon suggests that there are fundamental reasons for the NZD to remain very high (chart 10). RBNZ rate hike expectations provide further support for the level of the NZD. Furthermore, the high NZD does help offset building inflationary pressures within the New Zealand economy. Driven by these factors, the NZD TWI hit a new record high on 19 March 2014 (80.50).