Last June, 2017, Senior Deputy Governor of the Bank of Canada (BoC) Carolyn A. Wilkins stepped onto the stage with a surprisingly bullish message about the Canadian economy. This speech set the stage for the BoC’s rollback of “emergency measure” rate cuts that responded to the past collapse in oil prices. At the time, the Canadian dollar strengthened swiftly and sent USD/CAD from around 1.345 to 1.33. USD/CAD trended downward for three more months as markets adjusted to rising rate expectations. USD/CAD bottomed at that time around 1.21.
Since then, currency markets have swung wildly between hawkish and dovish interpretations of economic data and the Bank of Canada’s signals and speeches. The BoC’s latest Monetary Policy Report (MPR) was the perfect expression of this swirl of cautious optimism about the path forward. The report contained good news and bad news; net-net, traders decided to sell the Canadian dollar in what I suspect was disappointment in hearing anything that suggested the BoC is ready to resume rate hikes any time soon. This weakness, overlayed with the recent strength in the U.S. dollar, caused USD/CAD to rebound from the borderline of a breakdown below its 200-day moving average (DMA) to a challenge of its 50DMA.
The BoC today left its target for its overnight rate at 1¼%. The Bank Rate is 1½% and the deposit rate is 1%. More importantly, the BoC made it clear it is too worried about downside risks to get serious about mapping out a path to higher rates as, for example, the U.S. Federal Reserve has done. This clarity only came after a question during the press conference: a member of the press directly told Governor Stephen S. Poloz and Wilkins that the message in the MPR is not clear. She asked them to sum up the future of monetary policy. Here is Poloz’s response paraphrased (emphasis mine):
“economy is in a good place, reached near its potential, inflation is at the destination of 2%. All is not quite normal. Interest rates are quite low. Without low interest rates, the economy would not be where it is today. There are headwinds acting on the economy: legacy from financial crisis, accumulation of debt, NAFTA, competitiveness, a long list. Fiscal and monetary policy is supporting economy. So how do things unwind in the background to keep economy where it is today?…given where the economy is, it is very likely that higher rates will be warranted over time but we can’t be definitive because of headwinds unwinding at different times. The economy is very likely to need SOME stimulus in the future.”
In this response, Poloz threw a lot of cold water on what is an otherwise bullish looking picture for the Canadian economy. This level of caution is of course purposeful and likely reflects a desire to prevent the Canadian dollar from continuing to strengthen. This strength is a surprise given rates are still climbing in the U.S. From the MPR:
“Despite the more robust US outlook, and expectations of additional monetary tightening, the US dollar is around 5 per cent lower on a trade-weighted basis than it was a year ago.”
So the BoC has to exercise caution in its bullishness lest the U.S. dollar’s surprising weakness channels a lot more strength into the Canadian dollar.
In good news, bad news fashion, the BoC slightly reduced GDP expectations for 2018 and notably increased its GDP projection for 2019, but also increased its estimate of Canada’s potential economic growth. On balance, the resulting output gap continued to suggest that accommodating policy remains well warranted. From the introductory statement:
“The economy is projected to operate slightly above its potential over the next three years, with real GDP growth of about 2 per cent in both 2018 and 2019, and 1.8 per cent in 2020. This stronger profile for GDP incorporates new provincial and federal fiscal measures announced since January. It also reflects upward revisions to estimates of potential output growth, which suggest the Canadian economy has made some progress in building capacity…”
From the MPR:
“With this Report, the Bank provides its annual reassessment of the ranges of potential output growth. Potential output growth is expected to be stronger than estimated in April 2017, at 1.8 per cent between 2018 and 2020, and 1.9 per cent in 2021.”
During the press conference, Poloz talked about the output gap’s impact on the length of time required to get inflation to target (paraphrased): “some of it is related to updated data that shows capital stock is higher than thought. It means the gap between actual and potential output was bigger than thought.” If not for this commentary, I would have concluded that the story on the output gap was a firmly positive one.
Commentary related to trade was also telling. From the MPR (emphasis mine):
“Trade policy is an increasingly prominent risk to the global economic expansion. US tariff announcements and proposed retaliatory actions by China raise the risk of a more pronounced shift away from a multilateral, rules-based system. A wide range of outcomes are still possible for the renegotiation of the North American Free Trade Agreement (NAFTA). Even without changes in trade arrangements, increased concerns about trade policies could lead to a sharper-than-expected tightening of financial conditions, lower confidence and a more pronounced slowing of growth. The Bank’s base-case scenario, while predicated on the assumption that existing agreements will remain in place, continues to incorporate adverse effects from uncertainty on global investment and NAFTA-related judgment specific to Canada and Mexico.“
Canada’s export-dependent economy is particularly vulnerable to disruptions in the existing trade policy regimes. Under these conditions of policy uncertainty, the BoC cannot talk too much about the future tightening of monetary policy. Poloz noted during the press conference that the BoC has heard from businesses about their reluctance to invest until trade uncertainties get erased.
I am currently long USD/CAD and grew the current position through the 200DMA breakdown. My assumption is that in due time the rising rates in the U.S. will create enough divergence with Canada’s stagnant rates to propel USD/CAD higher. Since the low of September, 2017, USD/CAD has printed higher lows and higher highs. The current bounce is a key test of this slow rolling uptrend. NAFTA negotiations will be an on-going risk and caveat, but I think current trends indicate that, on-balance, risks favor upside for USD/CAD given current levels.
Be careful out there!
Full disclosure: long USD/CAD