CAD Vulnerable to Speculation as Canadian Economy Feels Effects of US Slowdown

CAD Vulnerable to Speculation as Canadian Economy Feels Effects of US Slowdown

 Published: June 1st, 2022

The Loonie has underperformed against its US cousin this week in price action that points to emerging vulnerability in North America’s currency complex versus other majors like Sterling in the coming weeks and months.

CAD was headed toward the bottom of the G10 league table at time of writing, having been outperformed by all but its US counterpart. When compared to G20 currencies the Mexican Peso was not far behind the Loonie.

Drifting CAD performance has helped the Pound to Canadian Dollar exchange rate stay north of the 1.60 level for the most of this week’s session and might free the pair to recover ground lost recently if it can sustain that handle through the coming weeks.

In a research briefing, CIBC Capital Markets’ Forex Strategy Unit said that ‘over the past few sessions, terminal rates (top cash rates) in have fallen close to 20bps in Canada. We believe US spillover is driving the trend.

'The impact is symmetrical. American trends can send domestic terminals higher or send them lower.

CIBC noted that market expectations for the Bank of Canada’s (BoC) top cash rate dropped this week in sympathy with their American equivalents.

This is significant since Canadian economic newsflow has been minimal n in recent weeks. It also wouldn’t be the first time CAD found itself tossed about on changing expectations for Federal Reserve (Fed) policy or changes in US economic conditions. When the US economic elephant sneezes, Canadian markets tend to catch a cold.

'The spillover effect into Canada from US bond yields could explain the stark differences between economic forecasts driven by domestic fundamentals, and market expectations that consider US Treasury spillover plus other asset prices as well,’ CIBC added.

Bond yields fall as debt prices rally

American government bond yields fell while debt prices swung back this week in what has been an unsettled stretch for global stock markets. At least some of CAD’s recent price action came hot on the heels of indicators pointing to slowing US economic growth.

In CIBC’s analysis: ‘In the core capital goods group of orders such as defense and aerospace, growth in April was just 0.3 per cent. This was below consensus 0.5 per cent growth.’

There have also been signals that at least some US Fed policymakers are ready to adapt their views on the extent to which US interest rates might have to rise in order to hold inflation down in the second half of 2022.

That might mean more US bond yield spillover that would affect borrowing costs in the great white north, with possible implications for market expectations of BoC monetary policy, Canadian economic growth, and CAD.

‘Markets are currently pricing in consecutive 50bps rate hikes from the Bank of Canada after its June and July meetings. Though we are largely aligned with investor expectations for these next two BoC meetings, after that our forecasts diverge,’ CIBC says.

'Investors see more rate hike sin the pipeline, with 2022 ending at 2.75 per cent. Based on our analysis, we believe the pace of interest rate policy delivery will slow down in the Autumn.’ Ultimately, says CIBC, Canda’s central bank will not be able to overshoot the neutral rate, which is currently forecast to settle at 2.5 per cent.

Anything that diminishes expectations for the Bank of Canada cash rate would affect Canadian bond yields and shape the spread between those yields and those in other G10 countries, with possibly favourable implications for a Sterling to Canadian Dollar rate, which some analysts currently see as overly discounted.

Currency analysts at Scotiabank told the Toronto Globe & Mail that ‘the technical signals are finely balanced. The Pound does still appear to be historically “cheap” and we believe the signs of a developing rebound have to be monitored carefully. Price action may lead to better support at closer to 1.57 today, but we are still looking for a push above 1.62 is needed before more, near-term gains are on the radar.’

Parts of the US economy may be cooling

One statistic CAD traders may be looking at is mortgage applications south of the border. A report from the US Mortgage Association published this week found that applications to refinance a home loan in the United States dropped two per cent for the week and were 75 per cent lower for the same week year-on-year.

Mortgage applications for a new home were also flat from the previous week and down 15 per cent from a year ago.

That’s despite US mortgage interest rates heading lower for the second straight week. Demand for new loans or refinances was negative, however US mortgage rates are still notably higher than they have been for the past two years. An average mortgage contract interest rate for a 30-year fixed-rate fell back to 5.44 per cent from 5.51 per cent.

‘Most borrowers looking to re-finance an existing mortgage have decided to stay on the sidelines, perhaps spooked by rising inflation and concerned about longer term economic trends,’ said the Mortgage Association in a press release. Refinance applications have dropped down for eight of the past nine weeks. Compared to January of this year, refinance activity has fallen 65 per cent.

New home buyers are also sitting out the current market, with applications for a mortgage to purchase a home were also flat. New home building is up so additional supply is headed to market, but houses are suddenly taking longer to sell.

Demand for home purchase mortgages has dipped to lows last seen in early 2020, when the coronavirus pandemic began. Home purchases surged after that, and manic demand has driven prices higher and higher for the past two years. That trend is now keeping potential buyers out of the market.

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