Currency Forecast - CAD: Modest Upside Ahead - OCT 2017

Canada Currency Forecast
Spot 2017 2018 2019
Updated: 2 October 2017
CAD/USD (ave) 1.2508 1.29 1.23 1.25
CAD/EUR (ave) 1.4684 1.46 1.35 1.44
Policy rate, % (eop) 1.00 1.25 1.75 2.25

BMI View: The Canadian dollar is due to take a breather following a significant rally versus its US counterpart since mid-2017. However, we see modest further upside between the end of 2017 and 2019 as oil prices continue to head up and Canadian mo netary policy tightens more aggressively than is currently anticipated by rate markets.

Short-Term Outlook (three-to-six months)

Our long-held outlook for a modest strengthening of the Canadian dollar through end-2017 amid increasing oil prices and an improving economy ( see ' Oil, Hawkish BOC To Strengthen CAD, 25 May 2017) has played out. The dollar recovered substantially from a 14-month low of CAD1.37/USD hit on May 4 before bouncing off trendline resistance at 28-month highs around CAD1.20/USD ( see chart). Our 2017 average forecast of CAD1.29/USD and end-of-year projection of CAD1.27/USD, however, imply that the currency is due to take a temporary breather, before settling in the mid-CAD1.20s/USD area over the longer run.

Taking A Breather
Canada - Exchange Rate, CAD/USD
Source: Bloomberg, BMI

Apart from the fact that the Canadian dollar failed to take out massive resistance at CAD1.20/USD, which is a negative technical signal, we believe that sentiment has gone from being far too bearish to far too bullish. The net non-commercial futures positions were the most negative in at least 25 years in May 2017, and this contributed in part to the currency's stunning reversal. With these negative speculative positions having unwound a long way, flipping to the most positive levels in nearly five years in September, the bullish CAD trade looks crowded and the impetus for more near-term currency upside is waning.

Short Squeeze May Prove Fleeting
CAD Net Non-Commercial Futures Positions
Source: CFTC, Bloomberg, BMI

Long-Term Outlook (six-to-24 months)

The Canadian dollar's recovery since mid-2017 is on solid ground fundamentally, but the rally has brought it close to fair long-term value. We forecast the dollar to average CAD1.23/USD over the course of 2018 and CAD1.25/USD in 2019, supported by higher oil prices and a recovering economy, which will see the Bank of Canada (BoC) tighten policy slightly more aggressively than the market anticipates.

The rise in oil prices is a key factor underpinning our positive outlook on the dollar given the importance of energy production to Canada's economy and the 75% correlation between oil prices and the currency over the past decade ( see chart). Our forecast for WTI crude at USD58/bbl in 2019 (versus USD51/bbl currently) implies an exchange rate in the mid-CAD1.20s/USD. The recovery in oil production and exports helped spur multi-decade highs in Canadian real GDP growth in H117, and is a key reason why the BoC is in a position to raise rates.

Oil Recovery To Benefit CAD
Canada - Exchange Rate, CAD/USD, and Oil Prices
Source: EIA, Macrobond, BMI

The BoC has raised rates in 2017 for the first time since 2010, with two 25bps increases in July and September. Markets anticipate a further 25bps hike by end-2017, followed by just one more 25bps increase in 2018. However, our core view is that the rate markets are too dovish, and we envisage one further 25bps hike this year (to 1.25%), followed by two more in each of 2018 (to 1.75%) and 2019 (to 2.25%) ( see ' More Rate Hikes To Come ' , 8 September). As this more hawkish path is priced in, it should offer the Canadian dollar a modest lift in 2018. However, appreciation versus the US dollar will be limited, as we also anticipate that the market is underestimating US Federal Reserve hawkishness as well, to a similar extent. Ultimately, Canadian rates will converge with the US Fed's path, with the 2019 rate more or less equal in both countries.

Similar Paths
Policy Interest Rates, % eop
f = BMI Forecasts. Source: Bank of Canada/Federal Reserve, BMI

Over the long run, CAD appreciation will be restrained by several factors, including lack of productivity growth ( see ' Structural Factors Will Constrain Growth ' , 7 October 2015). The chronic lack of relative productivity gains in Canada versus the US and other countries is one reason why, when the dollar appreciates much beyond CAD1.25/USD, Canadian non-commodity exports have historically struggled. The real effective exchange rate, whether measured in CPI or in unit labour cost terms, was 3-4% below its long-term average as of latest data in August, and we anticipate that the September data will show that the nominal appreciation has pushed the REER back to its long-term norm. Real appreciation from here will be mixed between both nominal and price-differential effects. Non-FX competitiveness is more likely to deteriorate rather than improve, as well: Canadian business regulations are getting tighter, the minimum wage is rising, and low unemployment is pushing up wages.

Risks To Outlook

Difficult trade negotiations with the US and Mexico over the North American Free Trade Agreement (NAFTA) are due to conclude at the end of 2017. While our core view is that there will be few changes to the core of NAFTA's provisions, there is a risk that the US could push hard to significantly alter trade terms in its favour and, in the worst case, see trade tariffs imposed on Canadian exports. This in turn would put downside pressure on the Canadian dollar.