cad fundamentals

2007 Second Quarter FX Market

Tuesday, 10 April 2007 21:05:10 GMT  |  Daily FX Research Team

USD/CAD Outlook
The Canadian dollar enters the second quarter stronger against the US dollar, but the gains have been hard won after the USD/CAD pair peaked at 1.1875 in early February. What was once the pride of Canada – their strong currency – has turned into a burden for the economy.

As a major trade partner of the US, the increasing value of the Canadian dollar against the US dollar has put a dent on export growth. Furthermore, the correlation between crude prices and the Canadian dollar have diverged over the course of the first quarter, despite the fact that oil production remains a crucial component to the Canadian economy. In the second quarter, a few big factors loom large for the Canadian Dollar, namely exports, domestic growth, the next big trend in commodity prices and the reliability of US demand.   

Exports Still the Linchpin of Growth, But For How Long?
Over the past four years, the Commodity Boom in oil has been the primary driver of the price action in the Canadian dollar. However this boom came to a screaming halt in 2006, when oil prices hit a high of $78.40.  By mid January 2007, prices ran below $50 a barrel, before rebounding in February.  The downtrend in commodity prices drove the current account surplus down from C$5.0 billion to C$3.0 billion in the fourth quarter and the Canadian dollar along with it. More recently, though, monthly measurements of the trade account look slightly more promising, with the January reading of the goods and services account rebounding back to C$6.35 billion. The prior weakness of the Canadian dollar played a major role in the turnaround in the overall economy, eventually taking the CAD to 1.1501 against the US dollar from prior lows of 1.1875.  However the renewed strength of the currency could also be what ends up killing the economy. If the Canadian dollar strengthens further throughout the second quarter as it has done in the first, the country’s primary trading partner – the US – may cut back on purchases of Canadian products and undermine the strength of the economy as a whole.  Furthermore, should commodity prices continue to ease back, the value of goods shipped out of the country could easily decline and erode Canada’s trade balance.

Employment the Key to Domestic Demand-Led Expansion
As foreign demand for Canadian products have started to dwindle, domestic consumption has slowly started to pick up as the booming oil sector provides jobs for much of the population of the Alberta region. The improvements in employment growth have become more widespread as well, as the 54.9K jump in net employment in March saw an acceleration of hiring in the services sector. However, this led to a slowdown in wage growth to 2.2 percent from 2.8 percent, as workers were hired in regions outside of oil-rich areas where work-shortages have driven up pay. Regardless, the effects of a stronger labor market have started to reflect in the broader economy, with retail sales (excluding autos) rising 0.3 percent in the month of January after surging 1.9 percent the month prior.  Additionally, IVEY PMI rose to 67.3 as businesses indicated improvements in not only employment, but prices as well. Furthermore, the leading economic indicator for the country rose 0.7 percent – the sharpest increase since June 2004 – as optimistic sentiment led equity shares, new orders for durable goods, and furniture sales higher.

On the other hand, the shift in the Canadian labor market towards the services sector has been to the detriment of manufacturing.  While this is generally a natural progression that has been witnessed in the UK and Europe – but most abundantly in the US – the Canadian manufacturing sector is still seen as a crucial part of the economy given the importance of exports. In fact, the easing in Canadian GDP in January to 0.1 percent – the slowest pace in four months – was drawn down primarily by manufacturing, which plunged 1 percent despite improvements in the trade report and the Ivey PMI report. Overall, the weaker figures could keep the Bank of Canada on edge regarding the downside risks of the manufacturing sector to expansion.

Hot Inflation – A One Time Event?
Since the Bank of Canada halted its series of seven-consecutive rate hikes in May 2006, inflation has come to the forefront once again as traders speculate on the future of monetary policy.  With a self-defined target rate of 2.0 percent growth, annual measurements have rebounded in the first quarter as the BoC’s own measurement of core CPI has surged to 2.4 percent – well above the central bank’s target. However, BoC Governor David Dodge said following the release, "Obviously it was more than most economists, including ourselves, were expecting...There could well have been some special factors in that, and we're going to have to evaluate, when we get a little more, whether there's any change there or not," effectively cautioning against putting too much emphasis on data from one month alone. Nevertheless, should price pressures fail to let up, the BoC will have little choice but to pay heed to CPI reports, which will likely keep the central bank’s benchmark rate at 4.25 percent.

US Growth and Canada – Waiting for the Other Shoe to Drop?
The close ties between Canada and the US are undeniable, as 75 percent of Canadian exports go to the US, creating a unique dynamic for the currency pair. Although growth in the US has been widely anticipated to slow substantially on the back of a slump in the housing sector, economic data has yet to consistently prove that this is happening. GDP has indeed slowed to 2.5 percent from 5.6 percent in early 2006, but the labor market has remained strong as March Non-Farm Payrolls surprisingly gained by 180K , driving the unemployment rate to a five year low of 4.1 percent. Furthermore, US purchases of Canadian goods have yet to fall back.  Consider this: the Canadian trade surplus widened to C$6.35 billion - the largest since December 2005 – as exports hit a record. Moreover, the trade balance with the US alone widened to C$8.73 billion in January from C$7.93 billion – the biggest surplus since January 2006. Overall, growth in Canada should remain supported by their southern neighbor so long as a major US slowdown is avoided. However, if US growth does become a concern like it did for part of the first quarter, we have seen how the Canadian dollar can behave as a result.  The currency completely shrugged off the rise in oil on the greater fear that a shortfall in exports to the US would be far more damaging to economic growth. 

What Happened to Oil?
While the consumer would be the most reliable driver of growth for the Canadian economy going forward, a second wave in commodity-driven exports could also reignite growth. The key to a raw-material led rebound is the volatile crude oil.  However, while Canada remains the largest source of oil the United States, the USD/CAD negative correlation with crude prices has slowly and inexplicably weakened. This was particularly surprising given the recent surge in oil above $68/bbl after Iran took 15 British soldiers hostage and crude’s subsequent decline after their release. Nevertheless, it will be important to watch how the oil-Canadian dollar correlation plays out, as crude has little potential of falling out of style and prices could eventually move in sync one again.

Conclusion
The extent of the inter-dependence between Canada and the US will likely dominate the fundamental direction of the USD/CAD currency pair into the second quarter of 2007.  Should US growth actually flounder in the near future as many analysts and economists have forecast, the Canadian economy will likely suffer the burden of constrained demand from its largest export market. Furthermore, more traditional issues will take root for the Canadian dollar as domestically-driven growth factors like consumer spending, housing construction and factory activity will play an integral role in gauging the direction of locally-led demand.  Finally, a close eye will always be kept on crude and other commodity prices for a strong return in the correlation with USDCAD spot.

Technical USD/CAD Outlook
The USD/CAD rallied to the channel resistance that we discussed in our 2007 first quarter forecast and has turned down in what may be the 5th of the 5th wave in the entire bearish sequence that began in 2002 at 1.6189.  Coming under 1.1457 would eliminate the alternate count that labels the decline from 1.1879 as a 4th wave correction and increase the odds that a new low will be registered (below 1.0927).  Sentiment continues to improve following the bearish extreme that was registered in mid-January.  For the week that ended January 12th, net speculative positioning (COT) was at -84,906 and that number has been cut to -35,165 (as of the report that was released on April 3rd).  Interestingly, wave structures and COT readings for other currencies point to future weakness against the USD.  The CAD is the exception, thus the best trading opportunities going forward may be in the CAD crosses, particularly the EUR/CAD.            

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