#Investments — 04.08.2017

Canadian Dollar – Outlook Change

Guy Ertz & Martin Gallienne

The Bank of Canada has surprised markets about two weeks ago by announcing a rate increase and by suggesting a sequence a further hikes. The Canadian dollar strengthened quite sharply. Medium-term structural factors are limiting the upside potential for the currency.

We have adjusted our 3 and 12 month targets and expect 1.25 and 1.30 (CAD for 1 dollar) respectively. This means a stronger CAD than previously expected.

The Shift In Policy For The Bank Of Canada

The Bank of Canada (BoC) increased its policy rate by 25bp to 0.75% at its July 12 meeting. We foresee more rate hikes as we expect the economy to grow above potential over the next few quarters. It is realistic to assume that the Canadian authorities will follow a similar path compared to the US Fed. We expect the next US rate hike in March 18 and a total of 3 rate hikes in 2018.

Inflation has been weak recently but we think that it was related to “temporary factors” such as energy and auto. It is forecasted to accelerate and reach close to 2% in middle of 2018.

Markets evolutions already reflect this new information as we have seen 2-year bond yields rise from approx. 0.70 to 1.3% over the last few weeks. We thus expect a limited upside for the currency based on the interest rate outlook.

The USD/CAD Outlook For The Coming Months

Short-term we expect a lateral move for the CAD. We see little triggers for a further appreciation of the CAD both based on fundamentals and technical factors. As discussed, the change in expected interest rate differential is largely priced in. Technical indicators and indicators of overbought conditions both point to a short-term pull back. Our new 3-month target for the USD/CAD is 1.25 (value of 1 USD). This means a stronger CAD than previously expected.

For our 12-month target we are more cautious as some long-term risk factors, such as household debt, could weigh on the currency (see the next section). We expect the USD/CAD to move back to 1.30 over the coming year.

Medium-terms Risk For The Canadian Economy

While a strong rebound in GDP growth and a hawkish stance from the Bank of Canada are signs of a strengthening economy, the large household debt poses a threat. Indeed, we think that the increase in household debt to GDP over the last 16 years will eventually damage the economy.

When compared to Spain and Portugal before 2008, Canada has experienced a similar increase in household debt-to-GDP since 2000.  The historical evidence thus imply that the high household leveraging will eventually create an important credit-driven economic slowdown.

Moreover, the increase in house prices and indebtedness has been primarily driven by low interest rate and international capital inflows rather than fundamentals. A economic slowdown could then be observed when the Bank of Canada starts to raise rates more rapidly.