The Loonie is Lost in No Man's Land says BMO, but the Pound-to-Canadian-Dollar Rate is Set to Fall

Image © Pavel Ignatov, Adobe Stock

- Driverless CAD confines USD/CAD to directionless range.

- Oil price gains and Canadian tax-cut response are needed.

- But GBP/CAD set for 5% decline as Brexit day draws near.

The Canadian Dollar is lacking a clear narrative to drive it in one direction or the other at present, according to strategists at Toronto-headquartered BMO Capital Markets, who say the Loonie could remain in a "flat range" until the U.S. Dollar index tops out and goes into reverse. 

However, the same cannot be said for the Pound-to-Canadian-Dollar rate, which is projected to decline by nearly 5% before January and to underperform in 2019 as the U.K. departs the European Union but uncertainty over the future relationship continues to hang over the British currency. 

2018 has been a turbulent year for Canada's Dollar, as fears over the trading relationship with the U.S. and the Bank of Canada interest rate outlook have pushed it back and forth. But the second half of 2018 has seen what was a wide 10 cent trading range narrow to just 300 points. 

This new and narrower range will confine the USD/CAD rate until either the U.S. Dollar index capitulates or something else happens, such as a change in the oil price outlook, to move the Canadian Dollar one way or the other. 

"With USMCA drama hopefully out of the way, the market is struggling to find the next theme. Oil is a mixed bag. Both central banks appear likely to continue to tighten—in sync. If that’s the case, there’s no theme and the most likely outcome is a flat range," says Greg Anderson, global head of currency strategy at BMO, in the bank's fourth-quarter market review. 

Anderson says there are risks that could push the Canadian Dollar higher in the months ahead, notably U.S. ratification of the United-States-Mexico-Canada-Agreement (USMCA) struck back in September, which replaces the North American Free Trade Agreement. This will see U.S. tariffs on imported Canadian steel and aluminium lifted, delivering a boost to the Canadian economy.

A possible Canadian government response to President Donald Trump's tax cust is another source of potential upside for the Loonie over coming months, according to Anderson. The Globe and Mail reported in October that the government is entertaining measures that will improve Canada's competitiveness in the wake of Trump's tax cuts, although the paper says the response is unlikely to include any changes to tax rates.

"The main upside risks to USDCAD are broad USD strength and oil not rebounding from its risk-off plunge. At a 1Y horizon, election hedging could be perceived as an upside risk," Anderson says. "Our model has fair value at 1.3085 (close of 06-Nov). Fair value is trending higher so the model wants to buy dips. The model’s confidence intervals are widening due to weak and inconsistent correlations."

BMO's financial model estimates the USD/CAD rate should be trading just below 1.31 but the quality of its estimate is low because of a weakening relationship between oil prices, interest rate differentials and the Canadian Dollar. The breakdown in correlation between the Loonie and its traditional drivers underlines the extent to which the Canadian Dollar is lacking a "theme" to focus on.  

Anderson and the BMO team forecast that the USD/CAD rate will trade around the 1.30 level until January, before breaking lower once into the New Year. The Pound-to-Canadian-Dollar rate however, is forecast to decline from 1.71 Friday all the way down to 1.63 over before year-end as the Pound underperforms ahead of the U.K.'s departure from the EU. 

"Once a UK/EU Withdrawal Agreement (WA) is reached, we think the resultant rally in the GBP will be underwhelming. The WA won’t settle the future trade relationship; it will just delay the “cliff edge” risk," says Stephen Gallo, Anderson's European counterpart. "Even a WA that passes the lower house will likely incur a large degree of political fallout. As such, we still see a high probability of a “hard/cliff edge” Brexit."

Sterling has underperformed other currencies in recent months as markets, and British voters, wait for Prime Minister Theresa May to unveil a likely-contentious deal covering terms of the U.K.'s withdrawal from the EU. 

Both sides have said disagreement over how to manage the Northern Irish border in the event another deal covering future trade cannot be reached is the main impediment to PM May being able to strike a withdrawal agreement.

"Spot GBPUSD has been almost completely overwhelmed by Brexit. All other fundamental drivers including economic data and interest rate differentials have declined in importance in terms of their influence over the pair," Gallo writes.

The EU has insisted Northern Ireland should remain in its customs union and single market if a trade deal is not reached, which would amount to an annexation, or abandonment, of the province. Northern Irish MPs have threatened to topple the government if PM May strikes a deal that sees the province treated differently from the mainland.

PM May has attempted to strike a compromise that would see all of the U.K. remain within the customs union and the single market, drawing the ire of Brexit-supporting British MPs, who say such an agreement would betray the majority who voted to depart the EU. Those MPs are still a distinct minority in parliament.

But May needs support from Northern Irish and Brexit-backing MPs, as well as the remain-supporting members who make up the remainder of the parliamentary party, if she is to avoid having to rely on the opposition to get her onto the statute book. It's far from certain that the opposition Labour Party would lend its support to the government.

Jo Johnson, a junior transport minister in Theresa May's government and brother of her leadership rival Boris Johnson, resigned from office Friday in protest at the Prime Minister's "deranged" plan for withdrawing from the EU. A remain voter in the first referendum, he has called for a second referendum.

The 11th minister to resign from government in the previous 18 months, Johnson's departure underlines the extent of current tensions in British politics and sent the Pound lower into the weekend. 

The Pound-to-Dollar rate was quoted 0.66% lower at 1.2979 Friday while the Pound-to-Canadian-Dollar rate was down 0.06% at 1.7163. 

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