Expect headwinds for the loonie

With slowing economic growth and persistent geopolitical risks such as the U.S.-China trade war, the loonie faces challenges — even with diverging monetary policy on either side of the border.

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On Wednesday, the Bank of Canada (BoC) held its key policy rate at 1.75%, while the Federal Reserve shaved 25 basis points off its target rate, which now sits in the range of 1.5% to 1.75%.

In an interview earlier this month, Luc de la Durantaye, CIO and managing director of multi-asset and currency management at CIBC Asset Management, said that, over the medium term, “we don’t see the support or impetus for the Canadian dollar to strongly outperform the U.S. dollar.”

For example, he noted that Canadian households and corporations have more debt than those in the U.S. According to data from the Organization for Economic Co-operation and Development, Canada’s household debt is about 181% of net disposable income, while that of the U.S. is 109%; and the two countries’ debt-to-surplus ratios for non-financial corporations are 7.9 and 7.7, respectively.

Based on such data, “Canada’s economic activity might continue to be sluggish, maybe even a bit more sluggish than in the U.S.,” de la Durantaye said. And in a sluggish growth environment, “oil prices are not necessarily going to be moving in the top end of their recent ranges,” he added. That means the loonie won’t get much lift from the commodities market.

It also means a BoC rate cut could be forthcoming. In a foreign exchange report published Monday, CIBC Capital Markets said slower spending by Canadian consumers combined with global growth deceleration would support CIBC’s call for a 25-basis-point cut by the Bank of Canada in January, with subsequent loonie depreciation.

In a statement announcing its rate decision on Wednesday, the BoC said it will continue to monitor how the global slowdown spreads beyond investment and manufacturing. Specifically, it said it would monitor changes in consumer spending and housing, and post-election fiscal policy.

On the positive side for the loonie, if the Federal Reserve lowers interest rates beyond current expectations, the U.S. dollar would lose the interest rate support from which it has benefited the last couple of years, de la Durantaye said. In such a scenario, cyclical currencies like the loonie would be stronger relative to the U.S dollar, he said.

On the other hand, in the case of increased market volatility, the U.S. dollar would act as a safe-haven currency and gain ground. However, the U.S. dollar is “already fairly overvalued,” de la Durataye said. “We would rather be in the yen, the Swiss franc, and even in certain cases the Chinese renminbi as a diversifier and as a way to protect the portfolio rather than have a big bet on the U.S. dollar on the upside.”

CIBC Capital Markets forecasts the loonie to sit at $1.31 relative to the U.S. dollar at year-end, based on the Bank of Canada standing pat on rates while the Fed cuts once (which includes Wednesday’s move). A potential BoC rate cut at the beginning of the year would see the loonie depreciate to $1.33 relative to the dollar in the first quarter of 2020.

Longer term, CIBC calls for a weaker loonie, reaching $1.38 relative to the U.S. dollar by year-end 2020, as a way to address current trade imbalances and rotate the economy toward business investment and the export sector.

For a full currency outlook, read the report from CIBC Capital Markets.

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