Canadian Dollar to Strengthen Further say BMO Capital Markets but Election Could Scupper the Loonie in 2019

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The Canadian Dollar will strengthen further over coming months as unease over the nation's future trading relationship with the U.S. dissipates although a range of factors could scupper or delay the currency's northward push next year, according to Toronto-headquartered BMO Capital Markets. 

Sunday's deal to save the North American Free Trade Agreement (NAFTA) has removed a Domocles Sword, or the White House threat of a U.S. withdrawal, from above the economy's head and given a green light for the Bank of Canada (BoC) to go on with its push to gradually raise its interest rate. 

"The USDMC deal has pushed USDCAD to 1.28; now the market doesn’t have a clear driver. We don’t expect much movement through the end of 2018, but we think risk factors are a bit skewed toward a lower USDCAD," says Greg Anderson, head of currency strategy at BMO Capital Markets. "We think USDCAD will drift lower in 2018 as the growth gap narrows and the USD index loses upward momentum."

There was previously considerable uncertainty about the path of BoC monetary policy given the trade talks were deadlocked right up to the last minute.

Now markets have a clearer view of not only the road ahead for the Canadian economy, but also the Federal Reserve's view of its own interest rate outlook. 

However, the path ahead for the Loonie is not a simple one because there still reasons to expect periodic bouts of weakness in Canadian exchange rates.

"BMO’s econ team expects the Fed to hike 3 more times over the next 9M but OIS only has 2 hikes priced in. The CAD OIS curve has 3 BoC hikes priced in, which matches our expectation. If we’re right on the Fed, interest rate differential should move 25bps in the USD’s favor," Anderson adds. 

BMO also says uncertainty over the outcome of the 2019 general election could also undermine the currency because foreigners earning Canadian Dollar revenue might choose to hedge their exposure to the currency. This would involve betting on a decline in Canadian exchange rates, which could turn fears of weakness into a self-fulfilling prophecy.

But there are still plenty of reasons to think the USD/CAD and GBP/CAD rates will remain under pressure over coming quarters, which is bad news for U.K. and U.S. based companies and consumers that are seeking to buy the Canadian currency.

The BMO currency team flags the prospect of Canada carrying out its own tax reforms, as well as a renewed focus in the market on U.S. fiscal vulnerabilities as grounds for thinking the Loonie will prevail over its rivals in the year ahead. 

"There are rumors that Trudeau and Morneau are working on tax reforms designed to enhance competitiveness (like accelerated depreciation). Details are likely to emerge in the Fall Fiscal Update," says Anderson, before flagging forecasts of a further deterioration in America's so-called twin deficit as another reason to think USD/CAD will decline further.

The Congressional Budget Office says President Donald Trump's 2018 tax reforms will add $1.5 trillion to the U.S. budget deficit over the next decade, a view that was supported by separate analysis from the Joint Committee on Taxation.

This means the U.S. will have to borrow more from domestic savers and overseas lenders during the years ahead, which analysts say will lead to a widening of the current account deficit. The market consensus is that this will soon undermine the U.S. Dollar. 

"Large deficits in the fiscal and current accounts undermine the credibility of a currency, with -5.0% for the sum of those deficits being a key threshold. The US ‘twin sin’ score was - 5.8% for 2017 and is forecast to deteriorate to -6.5% for 2018. Canada’s twin sin score was only -3.8% in 2017 is forecast to shrink to -3.6% for 2018," Anderson writes. 

The BMO currency team forecast the USD/CAD rate will fall to 1.27 before year-end and that it will decline to 1.24 before the end of September 2019.

They predict a similar outcome for the Pound-to-Canadian-Dollar rate, which is expected to decline to 1.57 by year-end and 1.51 by the time the U.K. departs the European Union at the end of March 2019. Although BMO forecasts a recovery to 1.75 for the GBP/CAD rate before the end of September 2019. 

The USD/CAD rate was quoted 0.15% higher at 1.2838 Wednesday, close to a six-month low, after whittling a near-4% 2018 gain down to just 2% since Sunday.

The Pound-to-Canadian-Dollar rate was up 0.06% at 1.6648 and is now down 1.9% for 2018 after more than reversing an earlier 1.34% gain.

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