The outlook for the Canadian dollar (CAD) can, to a large extent, be drawn from that which underpins our general view of the US dollar. Assuming that a renewed outflow of capital from the US will trigger the restoration of the long-term dollar downtrend in the months ahead, the CAD should perhaps be well placed as a default beneficiary – given its status as commodity currency and the ongoing strength of the Chinese economy. That said, with global investors arguably under pressure to raise their game in the remainder of the year, the CAD – the so-called ‘loonie’ – is not an assured winner.
If the Bank of Canada (BOC) felt confident about its 2005 GDP forecast of about 2.5 per cent, a pick up in activity from Q4 (when GDP expanded by a disappointing quarterly annualised 2.1 per cent) would help. As it turned out, growth did rebound, but by less than expected: 2.3 per cent.
Fortunately, recent spending data seem to have garnered a degree of positive momentum. The 1.2 per cent slide in retail sales in December may have paved the way for a comfortable rebound but the 1.6 per cent growth rate took the market by surprise. Sales increased a further 0.2 per cent month-on-month in March (beating expectations of -0.4 per cent) producing a quarterly growth rate of 2.4 per cent. That was the largest quarterly gain in more than three years.
Recent labour data have also been strong. Employment rose by 29,300 in April. That helped to take the unemployment rate down to a four-and-a-half year low of 6.8 per cent. Should unemployment continue to fall as it has, spending growth will be afforded a more sustainable footing.
As far as the foreign exchange market is concerned, reassurances from BOC governor David Dodge that interest rates will have “to rise over time” may begin to ring hollow if economic growth is not conducive to the bank’s forecast for core inflation of 2.0 per cent by the end of next year. To a large extent, low inflation (currently 1.2 per cent) has precluded the BOC from mirroring the US Federal Reserve’s “measured” strategy in reducing its accommodative monetary stance, leaving rates at 2.5 per cent again last month. The notion that this process could come to a standstill cannot be dismissed. The loonie’s bout of weakness since March has been compounded by the growing interest rate differential with the US. Hence, with the BOC on hold until inflation data, or a severe weakening in the CAD, convince it to do otherwise, the risks to the CAD in the near term remain on the downside.
The longer term outlook is a different story. Since the beginning of 1999, there has been an 82 per cent correlation with the CAD’s performance against the dollar and the CRB committee price index, which rises to almost 90 per cent if the past three years alone are considered. In the absence of both a sudden and marked weakening in Chinese demand for commodities, and a sudden divergence from the path of Canadian economic growth envisaged by the BOC, the loonie’s star should rise again.
Recent price action and a renewed interest in Canadian assets (according to the Bank of New York’s iPFM data) could suggest that the worst is over for the CAD, but if the recent momentum shown by US data releases is sustained, this will again serve to highlight the contrasting choices facing the Fed and the BOC – potentially to the detriment of the CAD.
Neil Mellor is a currency strategist at the Bank of New York
Researched and published in association with The Bank of New York
