CAD: Run down the slope of the dollar – Deutsche Bank

The Canadian economy has been on a tear with growth of 4.2%YoY in May leaving the Bank of Canada behind the curve while the repricing of the Canada curve has been drastic and with it the level of the Canadian dollar, explains Sebastien Galy, Macro Strategist at Deutsche Bank.

Key Quotes

“The consequence is a shock from a higher currency and much higher interest rate which tighten overall activity and should impact activity in Q3 and especially Q4. Seeing this, the Bank of Canada is likely to adopt a prudent pace of tightening hiking in October and twice more next year lagging the Fed. The market currently prices in such a scenario so that the open question is whether USDCAD is in an unstable equilibria and where will it converge.”

“The odds are that given the brutality of the adjustment fully in line with rates that the currency overshot the mark and is now in an unstable equilibria. If we look at the current account, the CAD would be too expensive but certainly not if we strip it down to a likely steadily improving trade balance. If we look at absolute PPP, CADUSD is cheap by around 0-6% depending on the concept. If we look at it on the basis of econometric models, we are likely to be far too early to correctly price in the latest structural break so that their value is extremely limited.”

“The extremely high correlation between spot and rate differential has likely been reinforced by systematic trading strategies and timing its breakdown is at best difficult. Nonetheless, the odds suggest that USDCAD is likely to stay even or drift towards 1.30 with a peak at 1.33 before drifting lower on USD weakness. As such our USDCAD forecast assuming a 1.32 profile is overly optimistic and should be pegged down to 1.28 in anticipation of some additional USD weakness.”

“Our economists reviewed the key factors behind CPI weakness and a key one – housing – is unlikely to be supportive keeping the Fed less hawkish than would be expected. A secondary factor is oil prices determined by expected supply and demand. Given the heavy fiscal outlays in many of these countries, it is difficult for them to accept further supply cuts at the time when shale oil output is increasing in the United States and developing in Canada. As such, the odds are that oil prices are more likely to act as a drag on the Canadian economy without being a clear driver for the Canadian dollar – as it once was.”