Expect lagging loonie in 2018

Many investors were caught off guard last year when Bank of Canada rate hikes sent the loonie on a tear. While the currency’s had a strong 2018 so far, could the Canuck buck surprise again this year?

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If it does, its trajectory this time could be downward. “The Canadian dollar is vulnerable,” says Benjamin Tal, deputy chief economist at CIBC.

To explain why, he describes the economic backdrop.

“This [economic] cycle is old,” he says, “Usually at this point, interest rates rise, inflation is rising [and] wages are rising,” but that’s not currently the case.

Instead, “Inflation […] is missing in action, [and] we don’t see any wage pressure,” he adds. “That’s the main reason why interest rates remain relatively low.” And, even though rates are expected to rise in 2018, “actual interest will be minimal at best, reflecting very muted inflation,” he says.

In such an environment, says Tal, “The question is what the Bank of Canada will do relative to the Fed and what it means for the loonie.”

Read: Equity returns, rate-hikes and risks: experts weigh in

Speaking prior to last week’s unemployment release and subsequent revised BoC calls, Tal said he expects the BoC will hike more slowly than the market expects, and more slowly than the Fed. It’s a viewpoint supported by three forces, he added.

Read: December unemployment rate could push BoC hike

First, “this is a [central] bank with an agenda,” Tal said. “The Bank of Canada would like to see the dollar going down, not up, […] to prevent a situation in which interest rates in Canada are rising faster than interest rates in the U.S.”

Second, we have a slowing Canadian economy, with the days of 4.5% GDP growth over, said Tal. He’s calling for 2% to 2.5% GDP for 2018, and says “there is no need to raise interest rates significantly” as a result.

Read: Canada’s GDP unchanged between September and October

The last force acting to keep the BoC in slow mode is NAFTA.

“The market is mispricing NAFTA, [which] is a real risk,” said Tal. “There will be some bad news [regarding] NAFTA over the next year, and that will have a negative impact, clearly, on the Mexican peso—but more so on the Canadian dollar.” It’s yet another reason why the BoC won’t significantly raise rates, he says.

That could leave the loonie lagging in 2018, said Tal, despite recent strength.

Global currency outlook

Regardless of NAFTA’s ultimate outcome, Tal suggests shorting the peso.

“You don’t need to kill NAFTA,” he says. “You just have to see the uncertainty level regarding NAFTA rising, and that will be the case in 2018. That’s enough to hurt [the peso and loonie].”

Similarly, he doesn’t favour the pound in the face of Brexit uncertainty, so he suggests investors “long the euro versus the British pound.”

In contrast, the yen could be a gainer. “Japan is surprising on the upside, and it’s possible that the Bank of Japan will move earlier than the market is expecting,” either this year or next, says Tal.

Despite a vulnerable loonie, “there are some ways to play the F/X market,” he says.

Read:

5 economic trends to watch in 2018

What the Liberals will focus on in 2018

Brace for a bumpier ride in 2018: Unigestion

This article is part of the AdvisorToGo program, powered by CIBC. It was written without input from the sponsor.