Canadian Dollar Outlook Clouds in Wake of Latest Rate Hike but Some Still Eye Recovery

-CAD faces fresh losses in the short term, say analysts.

-But year-end should mark a turning point for the Loonie.

-When slower Fed and NAFTA resolution will support recovery.

© COSPV, Adobe Stock

The Canadian Dollar outlook is in focus in the wake of the July 11 interest rate hike delivered by the Bank of Canada, with analysts questioning the potential pace of further interest rate rises ahead.

Forecasts for both interest rates and the Canadian Dollar are diverging, with some suggesting continued rate rises and a recovery from recent lows could be in prospect, while others warn of steeper losses to come.

"With the Bank still on a highly data-dependent path, growth running above their projections in October will keep another 2018 rate hike in play. As things stand today, the 2.8% predicted growth for 2018Q2 looks a touch optimistic, and if the economy can't clear that hurdle the most likely course for the Bank is still to stay at 1.50% into early 2019," says Mazen Issa, a senior FX strategist at Toronto-based TD-Securities.

Debate about the Canadian Dollar outlook comes right after the BoC raised its interest rate by 25 basis points to 1.5%, marking a fourth increase of the cash rate in the last 12 months. 

The bank cheered a resilient performance from the global economy and signalled it will continue raising interest rates at a "gradual" pace during the quarters ahead, so long as economic data warrant such moves.

It also warned of mounting risks to the economy due to President Donald Trump's trade policies, which could yet scupper the BoC from raising interest rates again in 2018. 

"Given the escalation in global trade tensions and a curve already reflecting "gradual" tightening suggests that the CAD's return profile remains asymmetrically tilted to the downside. We remain biased for USDCAD to re-test its 2018 highs in the coming weeks and months," says Issa. 

Above: USD/CAD rate shown at daily intervals.

USD/CAD was quoted 0.06% lower at 1.3199 Thursday but has risen by 4.4% so far in 2018. The Pound-to-Canadian-Dollar rate was 0.02% lower at 1.7438 but is up by 2.9% this year.

Both performances represent heavy losses for the Canadian Dollar, particularly after taking into account that the Loonie was up by a similar measure against the greenback and Sterling until around the end of the first-quarter.

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

Issa and the TD Securities team are actually uncertain as to whether the BoC will raise rates again, although they say the Canadian Dollar will see fresh losses during the weeks ahead regardless of the interest rate outlook. They have advocated that clients bet on the USD/CAD rate rising to 1.35 in the next month or so, placing a stop-loss around 1.2880.

Others, while not ruling out further losses in the next month, have a more positive outlook for the Loonie overall.

"The key drivers for USDCAD in 2018 (thus far) have been NAFTA and the interest rate differential," says Greg Anderson, global head of FX strategy at Toronto-based BMO Capital Markets. "The BoC has hiked twice in 2018 (Jan & Jul) and the Fed twice (Mar, Jun). From here on out, we expect the BoC to hike once more in 2018 (add Oct or Dec) and the Fed twice more (add Sep & Dec)."

Anderson and the BMO FX team forecast the Canadian Dollar will recover gradually over the next 12 months, although most of the upside will only come once into 2019 when markets are likely to question how much longer the Federal Reserve can go on raising interest rates for and the North American Free Trade Agreement negotiations begin to make progress. 

"The market is now expecting a ‘zombie NAFTA’ scenario which means that talks proceed slowly as leaders await the US midterm election results and the seating of Mexico’s new government. Resumption of talks in 2019 would be CAD-positive. We’re still somewhat less pessimistic about this factor than the market," Anderson adds. 

Officials from both sides of the US-Canada border have been attempting, without success, to renegotiate the North American Free Trade Agreement for nearly a year now. Analysts have previously estimated a US withdrawal from NAFTA could see the Canadian Dollar fall by 20%. The BoC also frequently flags the trade saga as a significant risk to growth.

Anderson and the BMO team forecast the USD/CAD rate will fall to 1.30 before the end of September and 1.29 by the time the year is out, although in 12 months time the exchange rate is predicted to have fallen all the way back to 1.25. The Pound-to-Canadian-Dollar rate is expected to hold steady around the 1.74 level until year-end, before rising to 1.78 in 12 months time.

Forecasts from the FX team at ABN Amro support the views of both TD Securities as well as BMO Capital Markets and are quite optimistic in their outlook for the Loonie.

"It is likely that the Canadian dollar will weaken again in Q3, as we expect lower oil prices on the back of profit-taking, and some further US dollar strength. Thereafter, the recovery of the Canadian dollar should begin in earnest," says Georgette Boele, a senior FX strategist at ABN Amro.

Boele says three more interest rate rises before the end of 2019 and a possible renegotiation of the North American Free Trade Agreement can help lift the Canadian Dollar toward the end of 2018 and into next year. She forecasts the USD/CAD rate will rise to 1.33 before the end of September before falling steadily to 1.28 in time for year-end and 1.22 by the middle of 2019. 

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