Canadian Dollar: A Little Less About Oil, a Little More about Rates

Of the majors, only sterling was weaker than the Canadian dollar in Q3.  Sterling's drop was a function of its decision to leave the EU and ease monetary policy.   The Canadian dollar fell 1.6% compared with sterling's 2.6% fall.  The other dollar-bloc currencies were among the strongest of the majors, with the Australian dollar rising almost 3% and the New Zealand dollar gaining a little more than 2%.

Many investors continue to see the Canadian dollar as a petrol currency.  However, in recent months, this relationship has loosened.  Consider that at the end of the Q2, the 60-day rolling correlation between the percentage change in the US dollar against the Canadian dollar and the percentage change in the price of light sweet oil was a little more than -0.70, which is the most extreme it has been since oil turned in mid-2014.

It became less extreme over the course of the quarter.  Yesterday, it reached -0.45, the weakest correlation since March 2015.  In the nine months here in 2016, the US dollar has moved against the Canadian dollar in the same direction that oil moved in five.

Another driver, which in our work is often present, may be at work: interest rates.  Here are two charts that illustrate our point.  The first Great Graphic, composed on Bloomberg, overlays the US two-year premium over Canada (white line) and the US dollar against the Canadian dollar (yellow line).  The purpose here is just to illustrate the co-movement.

Correlations cannot be eyeballed.  We looked at the rolling 60-day correlation between the percent change in the US dollar against the Canadian dollar and the percent change in the two-year spread.  This is depicted in the second Bloomberg chart.  At the end of last month, the correlation rose to nearly 0.55.  It is not far from that now.  To appreciate the significance, one has to go back to the late-1990s to see a higher correlation.

Over the past three months, the Canadian two-year yield has risen by nine bp and the similar US yield has risen by 25 bp.   Canada is in no position to match a Fed hike, even if they do not cut rates again.  

Although it will be overshadowed by the US jobs report on Friday, Canada also reports its September employment data at the same time.  While the monthly numbers jump around the six and 12-month averages, have been fairly steady this year.  The six-month average has moved this year between 3k and 11k.  The 12-month average has been between 6k and 12k.

Yesterday, Canada reported a smaller than expected August trade deficit.  The C$1.94 deficit was the smallest since January, and the July shortfall was revised to smaller.  Exports rose for their third consecutive month, but are still off 2.5% year-over-year.  Canada's exports to the US are off a little more than 5% year-over-year and fell 1.6% in August alone.  

Canada's exports to the UK surged 25% in August, despite the depreciation of sterling.  Statscan reported that shipments to the UK accounted for the bulk of the increase in exports.  Canada's exports of unwrought gold to the UK rose dramatically, but probably is not recurring business.     Energy exports hit a two-year low in May and rose 5.3% in August. 

Like several other countries, Canada continues to wrestle with risk emanating from the property market.  There seems to be a rough consensus among policymakers that interest rate policy may be too blunt of an instrument.  Instead, macro-prudential policies are preferable.  Earlier this week, Canadian Finance Minister Morneau announced new measures that may begin going into effect as soon as October 17. 

These measures include a stress test for home buyers and new income eligibility requirement for mortgage insurance.  Morneau warned that see an 8% decline home sales, which is around the decline seen between April and August this year.  Some private sector estimates suggest a larger hit.

The US-Canada lumber dispute will also come to a head by the middle of October.  The previous arrangement that put a tariff on Canada's softwood lumber imports to compensate for Canadian producers access to cheap lumber from government lands expired a year ago.  Over the past year, Canada has been able to export lumber to the US duty-free, and it has.  Canadian exports of lumber to the US have risen by nearly a quarter. 

If there is no agreement on October 12, US companies can initiate new trade cases. US producers want to limit Canadian imports to a fixed market share.  Some Canadian producers want to choose between a tariff model and an volume cap, like the last agreement. 

The US dollar fell from almost CAD1.47 at the end of January to CAD1.2460 in early-May.  Since then it has bounced along its trough, never getting above the CAD1.33 level, which corresponds with a 38.2% retracement of the fall.    Based on our expectation for a December rate Fed hike, and two hikes next year, over the medium-term we expect the US dollar to work its way above CAD1.3575 (50% retracement) and more toward CAD1.3840 (61.8% retracement and congestion area from last February. 

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