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Canadian Dollar is a Buy at RBC ahead of the BoC, but Others are Growing Cautious

Image © Bank of Canada, Reproduced Under CC Licensing

- CAD tipped as a buy at RBC ahead of July BoC decision.

- Strong economy sets BoC and CAD apart from G10 crowd.

- But ING says CAD risen as far as it's likely to in short-term.

- ING looks for CAD weakness in Q3, but strong 2019 finish.

- CIBC says BoC likely to be wary of CAD strength this week.

The Canadian Dollar has been tipped as a buy at RBC Capital Markets ahead of the July Bank of Canada (BoC) interest rate decision, which is due on Wednesday, although analysts at some other firms are growing more cautious in their outlook for the Loonie. 

Canada's Dollar has bested all of its G10 rivals this year and by a quite a distance too after oil prices recovered from their 2018 collapse during the early months of 2019 and as the economy rebounded out of an earlier trough throughout the second quarter. 

However, now many analysts are wary of a possible U.S. Dollar rebound that could see the USD/CAD rate bounce higher through the summer months so those that are still backing the Loonie for further gains are turning their attention to other rivals. RBC is recommending clients buy the Loonie and sell the Japanese Yen this week. 

"CAD outperformance has been a consistent theme over the last month and we think it can continue this week. The BoC is unlikely to introduce any easing bias as it leaves rates unchanged on Wednesday," says Adam Cole, chief currency strategist at RBC, in a note to clients. "We prefer to play CAD strength on the crosses, given our mildly USD-positive bias and note that CAD/JPY is one of the tighter proxies for general risk appetite in G10."

Above: CAD/JPY rate shown at daily intervals.

The Bank of Canada will announce its latest interest rate decision and economic forecasts at 15:00 Wednesday and although consensus is for the cash rate to remain at 1.75%, markets are looking for the bank to buck the developed world trend by signalling that rates will go unchanged for a while yet.

This would be a novelty for investors and one that could offer further support to the Canadian currency because developed world central banks have either cut rates already this year or are increasingly leaning in that direction.

Central banks in Australia and New Zealand have both already cut costs this year and are expected to do so again before the curtain closes on 2019. Markets are also betting the European Central Bank (ECB) will take its turn as soon as the end of July, but certainly by the end of September. 

However, the most notable example of a central bank in retreat is the Federal Reserve (Fed) across Canada's southern border. The U.S. central bank is widely expected to cut the Fed Funds rate range at the end of July and again in December, before reducing U.S. borrowing costs again next year.

"Although we see little scope for a dovish surprise at this BoC meeting - which suggests limited upside risk in USD/CAD – we are reluctant to expect another sharp appreciation of CAD just yet. In fact, it seems that the rates and FX markets have already priced in most of the positives," says Francesco Pesole, a strategist at ING Group. 

Above: Canadian Dollar performance Vs G10 rivals in 2019.

Many G10 central banks had as recently as late 2018, been looking to raise rates this year so their about-turn has seen the Canadian Dollar draw a significant bid from yield-hungry investors drawn to it by the allure of a cash rate that's higher than those prevailing in most other parts of the developed world. 

However, with the Loonie now up strongly for the year and having extended gains significantly in June, analysts at both ING Group and CIBC Capital Markets are becoming more cautious about the outlook. ING says all of the good news from Canada is now in the price. 

Official data showed Canadian wages rising by 3.6% during June, which followed two months of solid job creation from the economy. Inflation has also risen substantially above the 2% target of the Bank of Canada, which could pressure the BoC into raising rates later this year if price pressures are sustained. 

"We continue to expect policy rates to remain untouched over the next 18 months and believe that CAD will stay supported despite possibly facing kick-back from re-escalating trade tensions. Accordingly, we stick to our current USD/CAD forecasts at 1.30 for 4Q19 and 1.28 for 1Q20," Pesole writes, in a note to clients Monday.

CIBC is concerned the BoC might want to discourage further currency strength this week for the sake of its inflation target, which could see the bank tailor its language to dissuade investors from further bids for the Loonie. 

This is because a stronger currency can reduce inflation by making imported goods cheaper to buy. It can also weaken an economy by raising the cost of exports for foreign companies and consumers. 

Above: USD/CAD rate shown at daily intervals.

Changes in interest rates are normally only made in response to movements in inflation but impact currencies because of the push and pull influence they have over capital flows, and their allure for short-term speculators. 

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

"The Bank will keep rates on hold this Wednesday, but will have to tread carefully in order to restrain CAD strength. Domestic data has been very solid and the Bank should upgrade its forecast for Q2, but that should be offset by mounting concerns on the external front," says Bipan Rai, North American head of FX strategy at CIBC.

For its part, the Bank of Canada has said future rate decisions would be dependent on "developments in household spending, oil markets and the global trade environment." The comments appeared to make future hikes contingent on a deescalation of the U.S.-China trade war and a range of other factors. 

Presidents Donald Trump and Xi Jingping agreed at the end of June to avoid imposing further tariffs on each other and to resume talks aimed at addressing U.S. concerns over "unfair" trading practices, although it's far from certain the dispute between the world's two largest economies is over.

Meanwhile the WTI oil price, which is a significant driver of the Loonie, has risen 27% in 2019 and an agreement was struck just last week between Organization of Petroleum Exporting Countries (OPEC) to extend production cuts in order to sustain prices at their current higher level. 

"The loonie has been amongst the top performing currencies this year and how markets react will come down to whether the Bank is perceived enough to be very concerned on protectionism and trade war risk," says CIBC's Rai.

Above: Pound-to-Canadian-Dollar rate shown at daily intervals.

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