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The Canadian Dollar Ends the Year Not Far From Where it Started Against USD

Friday, 22 December 2006 17:02:47 GMT  |  DailyFX Research Team

USD/CAD Outlook

The Canadian dollar ends the year not far from where it started against the US dollar, which represents a modest recovery after USD/CAD hit 28 year lows back in June.  What was once the pride of Canada, which was their strong currency, is now the source of its biggest problems.  As a major trade partner of the US, the increasing value of the Canadian dollar against the US dollar has hurt trade as well as overall economic growth. 

The currency’s recent depreciation has not been unique to the US dollar.  Instead, the biggest loss is the currency’s value against the Euro.  Having rallied more than 1150 pips from the beginning of September, the price action reveals the sharp contrast in not only monetary policies, but also economic growth between the two countries.  In 2007, 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.   

The Life Blood in Exports Runs Thin

In the past four years, the Canadian dollar has been driven higher across the board by soaring global demand for commodities However as commodities have marked their very high tops in late summer, the primary source for growth has begun to dry up.  In the third quarter, the current account balance (the broadest measure of international trade) reported in with a C$5.09 billion surplus, dropping below its the five-year average. More recently, monthly measurements of the trade account look less than promising.  In the October reading from Statistics Canada, the goods and services account slipped to a C$3.8 billion surplus.  The key reason for the drop off in the data was the decline of trade with the US.  Since it is estimated that 85 percent of all Canadian exports are destined for the United States, a two-year low in shipments to the States crimps a major source of revenue.

Is Domestic Growth Up To The Task?

For the past year, as exports have struggled, domestic sources of growth have worked to pick up the tab.  This dynamic will become even more important in the months ahead as forecasts for trade continue to falter.  Over the past few months, Canadian consumers have been able to fill the gap as employment and wage gains maintained the momentum spurred by the export boom.  However, even labor trends have begun to sour since peaking at a 31-year low in the unemployment rate set in May and June.  Though wages easily overtake inflation at 2.9 percent annual growth, actual hiring conditions have deteriorated. For example, although November saw a net gain of 22,400 most of the hires were part-timers, while employers continued to cut full-time positions from the staffing books. Not surprisingly, this has led confidence to deteriorate to its worst levels for year which in turn has led retail activity to flounder. September sales excluding automobile sales dropped 0.9 percent, the biggest decline since December of 2004.  Although a rebound in big-ticket item sales led by rising housing starts may provide some lift to demand, the modest improvement may not be enough to offset the worsening slump in manufacturing. The cumulative effects of seven interest rate hikes and a rally in the national currency to a 28-year high against its largest trade partner, have hurt the sector.  The Ivey PMI manufacturing activity indicator has marked its own 11-month low, while shipments have slipped to near two-year lows.

Is There A Second Commodity Boom In Store?

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 reignite growth. The key to a raw-material led rebound is the volatile crude oil.  The largest source of oil for the largest consumer in the world, the United States, the USD/CAD historically holds a high, negative correlation to crude prices. This relationship has been a chief component in driving the Canadian currency lower as WTI crude has fallen nearly 25 percent from its peak through November.  Despite the idyllic conditions for a further ‘normalization’ in oil prices though, $60 still came in as a convincing floor.  The OPEC nations are partially responsible in keeping this support level solid.  In October, to stem the sharp declines in crude, the cartel announced that they would cut production by 1.2 million barrels a day.  The group further decided on another cut of 500,000 barrels a day at its normally scheduled December meeting to take effect on February 1st.  Now that the commodity has found a bottom under near-pristine conditions, any type of geo-political unrest could jar it higher.

Follow the Leader

The close ties between Canada and the US are irrefutable, and this relationship creates a unique dynamic for the currency pair.  Since the first quarter of 2006, growth in the world’s largest economy has decelerated substantially.  From a 5.6 percent pace of expansion in the opening months of the year, US GDP has slowed to a three-and-a-half year low 2.0 percent. Any sustained depression in US growth would further weigh on the already struggling Canadian economy.  According to Statistics Canada’s third quarter report, expansion was trimmed to a 1.7 percent annual pace, the slowest in three months.  The Bank of Canada’s Governor David Dodge has called the downturn ‘mild’ and ‘short-lived’; but without the support of demand from the nation’s largest trade partner, a downturn could turn into a hard landing.  Since international trade accounts for roughly a third of Canadian GDP, an extended slump in US growth could potentially undo any positive effects from a potential firming commodity prices or pick up in domestic spending.  

Tracking Inflation for the Bank of Canada

Since the Bank of Canada halted its series of seven-consecutive rate hikes in May, inflation has taken a back seat for monetary policy.  With a self-defined target rate of 2.0 percent growth, annual measurements are falling right in line with a neutral policy.  BoC’sM own measurement of core CPI has flirted with levels of price growth not seen since May of 2003, though this high actually comes in at 2.3 percent –only modestly above the rate expected to produce stable growth. Therefore monetary policy is heavily expected to be dictated by economic growth numbers rather than inflation in the coming months.

Developing Stories

Elsewhere in the economy, there are a few stories that have been relegated to the background but which could quickly commandeer the attention of the market. One of those stories was Finance Minister Jim Flaherty’s recent announcement of a new tax on income trusts.  Traditionally used to avoid corporate taxes, trusts pay income to unit holders in the form of distributions which are then taxed at a regular rate.  These instruments have been an attractive vehicle for foreign investors and their new tax status could curtail the flow of foreign capital to Canada.  Another huge source of incoming capital for Canada over the past year has been large cross-border merger and acquisition deals. Though the volume of such deals have waned through the end of the year as the economy cools, currency traders will keep an eye on future accords in key sectors like energy and industrial goods.  Finally, one story that has only begun to develop, but could raise political uncertainty and send the Canadian currency lower is the ongoing debate over an independent Quebec.  Prime Minister Stephen Harper recently tried to settle the long-standing argument by proposing an amendment that would refer to Quebec as a ‘nation…within a united Canada.’ Should this take hold, the question of where political authority lies could unnerve Canadian dollar holders.

Conclusion

The extent of the two countries’ inter-dependence will likely dominate the fundamental direction of the USD/CAD currency pair into 2007.  Should US growth continue to flounder in the near future, the Canadian economy will likely suffer the burden of constrained demand from its largest export market.  This could put both currencies on the chopping block for a best of the worst scenario.  Additionally, more traditional issues will take root for the Canadian unit.  Domestically-driven growth factor like consumer spending, housing construction and factory activity will play an integral role in the Canadian dollar’s direction.  And, as always, a close eye will always be kept on crude and other commodity prices for a strong return in the correlation between raw material prices and USDCAD spot.

Technical Outlook

The USDCAD continues to trade higher, but in a very choppy fashion.  RSI on the weekly is at its highest since May 2004.  A slightly downward sloping channel may be forming since the November 2004 low.  The potential resisting line to for that channel is at 1.1900 this week but decreases roughly 13 pips per week.  This channel fits nicely with the idea of a strengthening US dollar over the next few months as January high at 1.1796 would intersect the channel in March (the same month that reference points intersect in the EURUSD).  The USDCAD rally has accelerated lately, and if 1.1796 is given, then focus shifts to the November 2005 high at 1.1973.  A supporting trendline that dates to the beginning of September is currently at 1.1284 (today is December 15th) and increases about 11 pips per week.  Price above that line keeps the medium term bullish as bias one.  A break below that line opens up 1.1177 and 1.1028. 

USDCAD Weekly Chart (Source: FXTrek Intellicharts)

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