Loonie Recovery on the Horizon Says Bank of Montreal

Loonie Recovery on the Horizon Says Bank of Montreal

 Published: September 28th, 2022

Despite falling to its lowest level against the Greenback since July 2020 on Tuesday, CAD may be in line for one of the most significant G10 bounce-backs when (or if) the mighty US Dollar tops out, says a new forecast from BMO Capital Markets.

The Bank of Montreal investment unit says Canada's fiat ceded its position as the second-best performer of 2022 to the Swiss Franc on Friday 23rd September when it sunk to 73 cents against the American Dollar. In the upside however it held onto large gains over other G10 peers, some of which had sunk to multi-decade lows against the Greenback.

Leading the losers was GBP, which is on a downslide to hit its 2008 financial crisis lows against the Canadian Dollar after a break below the 1.50 handle. If BMO is right and the Loonie is tipped for a sharp recovery next year, GBP/CAD has room to plumb new depths in the months and quarters ahead.

‘The uptrend we’re seeing in USD is still the most powerful gravitational force in the currency universe. Bloomberg's Dollar index is up 16 per cent over the past twelve months, with the Fed's various indices all showing similar gains,’ says an investor note accompanying the BMO Capital Markets forecast.

‘When the Greenback uptrend reaches its apex, we believe CAD to be among a select handful of currencies that turns sharply.’ The note cautions however that 'it isn't time to call the end of the USD uptrend yet’. BMO believes the Feder Reserve will need to signal that the current tightening phase is approaching its end.

Canada's currency offers one of the highest interest rates on the G10 top table, thanks to central bank monetary policy that has seen the Bank of Canada (BoC) keeping interest rates largely in line with the US Fed. Washington raised the high end of the Fed Funds rate to 3.25 per cent earlier this week.

The Fed is also using its quarterly economic forecasts to warn that further rate increases are still in the offing, with the Fed Funds rate forecast to go above 4.5 per cent at some point in 2023. Whether or not that marks the peak will depend on prevailing trends in US inflation.

A petrocurrency no more?

Canada’s fiat has often been called a ‘petrocurrency’ due to Canada’s economic reliance on commodity exports and oil in particular. Forex traders have long expected its value to rise and fall in tandem with oil prices and traded the currency accordingly.

That oil price correlation began to break in mid-March of 2022 when CAD slipped against the US Dollar even as a significant rally in oil prices was taking place.

The price action shocked many traders, though analysts at CIBC bank in Toronto noted that the relationship between CAD and oil had been evolving for years. Many traders had simply not tracked how much that things had changed.

The bank’s currency research unit wrote in an investor note that ‘despite what we’ve witnessed in terms of CAD’s steadiness in the face of volatile crude prices, statistical evidence is building that supports the notion of a weaker link between oil and CAD, which tends to correspond with softening Canada-US interest differentials.’

Spring into losses

In late May the Loonie was underperforming against the Greenback, in price action that suggested emerging vulnerability in North America’s currency complex versus other majors like GBP.

On 30th May, CAD was headed toward the bottom of the G10 league table, having fallen behind all but its US counterpart. When compared to G20 currencies, the price of the Mexican Peso wasn't far off.

Analysts said that a dearth of recent Canadian economic date had left the Loonie vulnerable to trends south of the border. CAD often finds 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.

CIBC noted at the time that market expectations for the Bank of Canada’s (BoC) top cash rate had fallen in late May in tandem with their American equivalents.

A spillover effect from US bond yields could explain the stark differences between economic forecasts in Canada and America. These are being driven by domestic fundamentals, and expectations that consider US Treasury policy impacts plus other asset price moves’.

Another bank sees headwinds ahead

Analysts at Montreal-based Desjardins Bank said in July that the Canadian Dollar was headed for steady declines during the second half of 2022.

In a mid-year currency market analysis, economists at the Quebec bank’s FX Strategy Unit said the global economic outlook would be challenging over the coming months, a backdrop which will work against the Commodity-sensitive Loonie. Rising interest rates from the Bank of Canada (BoC) would add to headwinds by pressurizing Canadian households laden with credit card debt.

‘Global recession worries are already impacting the Canadian dollar, which isn't normally seen as a safe haven during times of upheaval. Markets are still disrupted, and risk-appetite remains weak across the board, though there have been occasional spikes of optimism.’

Investors were also expecting Canada's central bankers to raise interest rates by nearly 200 basis points over the coming six months as policy makers looked to quell rising inflation and stay in sync on rates with their counterparts at the US Federal Reserve.

‘Markets are looking for interest rate rises in Canada to be at the high end, though not high enough to nudge CAD’s value upward,’ Desjardins said at the time. ‘Hiking interest rates could also aggravate Canada’s high levels of household debt and even cause a significant correction in the residential housing market.’

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