The Canadian dollar is one of the best-performing major currencies in the world in April, rising three and a half cents against the U.S. greenback over the course of the month to a high of 82.5 cents on Thursday.
This rapid appreciation can be attributed to a perfect confluence of events.
After paring shorts through the month of March, hedge fund positioning on the loonie grew more bearish in the two weeks leading up to the Bank of Canada's mid-April interest rate decision, according to the Commodity Futures Trading Commission's weekly Commitment of Traders reports. Traders positioning for a dovish Bank of Canada on April 15 were likely disappointed, as Governor Stephen Poloz indicated that he believes the insurance taken out in January provided sufficient stimulus for the economy.
But, heading into that rate decision, the consensus call was indeed for Canadian dollar strength on the announcement – so much so that a number of economists and strategists recommended fading any rally in the loonie. However, investors who took that advice fared very poorly.
The loonie jumped the day after the Bank of Canada decision, with figures released that morning showing firmer than expected core inflation for March and solid growth in February's retail sales. This move likely forced out weak hands who had elected to short the Canadian dollar after the previous day's rally and triggered stops for traders who had held a short loonie position for a longer period.
The rise in Canadian bond yields has also incented Europeans, currently stuck with paltry – and in some cases, negative – yields on sovereign debt to purchase Canadian fixed income, a potential source of support for the loonie.
On the other side of the coin, the U.S. dollar index has come off its highest level since 2003 as a stretch of poor economic data is expected to push off the timing of the first rate hike from the Federal Reserve.
The icing on the cake was the recovery in oil prices. The front-month futures contract for West Texas Intermediate has risen from below $50 per barrel (U.S.) at the start of the month to above $58, which added fuel to the petroloonie's rally.
Credit Suisse, however, is still quite comfortable calling for weakness in the Canadian dollar despite the recent run-up.
Analysts Alvise Marino and Axel Lang expect the Canadian dollar to fall to 80 cents and about 75.8 cents relative to the U.S. greenback in three and six months, respectively.
This view on the Canadian dollar is more constructive than their previous estimate, as the analysts have been swayed by three factors:
- The expectation of fewer rate hikes from the Federal Reserve in 2015;
- The stabilization in crude oil prices and expectation that it will trade in a tight range over the next few months
- The Bank of Canada’s optimistic outlook for economic growth after a poor first quarter.
Of these factors, the third elicits the most cause for doubt, according to Credit Suisse.
Mr. Marino and Mr. Lang believe the oil shock's effect on investment will drag on Canadian growth "for a long time," quite unlike the Bank of Canada's call for a "front-loaded" hit to the economy.
Unlike the market, which is no longer pricing in another rate cut this year, Credit Suisse's duo doesn't rule out another reduction to the overnight rate in 2015.
Shorting the Canadian dollar is both a roundabout bet against oil prices (given the large role oil plays in the nation's terms of trade, which has a big connection to the exchange rate) and the performance of the Canadian economy. The two are, no doubt, intertwined to a certain extent.
To get a sense of how the downturn in oil prices will affect the Canadian economy and currency, Credit Suisse first examines how rising oil prices aided the nation's net international investment position (NIIP) – that is, the difference between foreign assets owned by Canadians and Canadian assets owned by foreigners – over the past two and a half decades.
Oil's fingerprints are all over the improvement in Canada's net international investment position, as the cumulative trade surplus in oil surged since 1990. The current account – the sum of the trade balance of goods and services, income earned or sent abroad on foreign investments, and net transfer payments with the rest of the world – has deteriorated since the financial crisis once oil is stripped out of the equation. This "underlying trend" of the net international position is conducive to further Canadian dollar weakness, according to Credit Suisse.
The analysts estimate that the energy sector directly contributed 20 per cent of nominal economic growth per year from 2002 through 2014, and had a greater impact when one considers the knock-on effects, like higher government revenues (and, in turn, spending) from oil companies, and the positive effect on consumption and housing due to the positive income shock and higher Canadian dollar.
"High oil prices have led to a large increase of borrowings for consumption and investment," write Mr. Marino and Mr. Lang. The latter was concentrated in the energy sector (whose prospects are obviously gloomier now) and the non-productive sector such as the housing market (whose prospects are also weaker given the negative shock to income)."
While the Bank of Canada has trumpeted the performance of the nation's non-commodity exports, Credit Suisse thinks the restoration of capacity in this space, which would offset the income shortfall from less activity in the oil patch, is still a ways off. The analysts also think Mr. Poloz may be overstating the extent to which non-energy exports have improved, pointing out that the 25 per cent year-over-year jump in the volatile aircraft shipments category has skewed the results.
Since the Canadian dollar will aid, at the margin, the nation's long-awaited rebalancing of growth toward exports and business investment, the analysts believe that strength in the loonie will be met by dovish commentary or a policy response from the Bank of Canada.
They highlight 83 cents (U.S) as a level that would make monetary policymakers uncomfortable with the potentially adverse impact on exports stemming from the Canadian dollar's strength.