Canadian Dollar Support May Come From Rising Inflation

The Canadian economy is becoming a standout amongst the developed nations which has started to generate support for the local dollar.  The sovereign debt issues in European, mounting budget deficits in the U.S. and U.K. makes a fiscally sound Canada an attractive destination for investors. The “loonie” has taken on an unusual role of a safe-haven in the midst of the current turmoil. However, don’t expect the com-dollar to develop a negative correlation with risk as it continues to hold a strong relationship with oil prices. The recent support is more of a vote of confidence for the economy which continues to show signs of improvement. A jump in housing starts to 186K from 174K combined with last week’s strong labor report is evidence of building domestic growth. The International Merchandise trade report declining by 0.2% for a second month is typically a negative and is a product of slumping demand. However, the shortfall in December was due to rising imports outpacing stronger exports.

BoC Governor Carney expects the economy to benefit from improving growth in the U.S. and emerging markets. The accelerating growth from developing nations “provides a base of support for our terms of trade,” stated the central bank leader. U.S. growth is “coming back stronger” in part because “it fell so far,” Carney said, adding the U.S. economy is “most relevant” for Canada. Policy makers have been reluctant to remove stimulus efforts and begin tightening until they are confident that the American economy is back on track. The central bank has pledged to maintain the current low interest rate environment until mid-2010. The lack of a threat of inflation has allowed policy makers to maintain their measured approach.

The upcoming consumer price report will garner considerable focus with economists forecasting a rise to 1.9% from 1.3%. The central bank has an inflation target of 2.0% and with core prices also forecasted to reach 1.9%, any upside surprise will make it difficult for the MPC to remain on hold. A rise in inflation will give added importance to the end of the week’s retail sales report. Improving domestic demand will make it easier for retailers to pass on additional costs. Increasing consumption combined with an improving labor and housing market is clear sign of growth and a recipe for inflation. Despite all of the potential bullish catalysts on the calendar, the outlook for global growth is dimming as government stimulus comes to an end and troubles in Europe mount. China increasing its bank reserve requirements in an effort to curb lending to consumers and small businesses will also weigh optimism, and potentially on the “loonie”. -JR