Why investors should keep a close eye on the loonie

As trade uncertainty continues, the loonie is losing ground—a development to which investors should consider paying heed.

This week the loonie reached a new 12-month low relative to the U.S. dollar. That means the Canuck buck is trading roughly in line with where it sat last June before the Bank of Canada began tightening in July 2017, notes a weekly market insights report from Richardson GMP.

The loonie is a “victim of collateral damage,” says the report, referring to two things: escalating trade uncertainty and economic weakness.

For example, increased protectionism would disproportionately hurt global and Canadian growth relative to U.S. growth, given that the U.S. is a big net importer, says the report. As a result, a growing trade war would likely continue to put upward pressure on the U.S. dollar relative to many of its peers, including the Canadian dollar.

Read: As tariff retaliations heat up, National Bank reconsiders investing strategy

Economic data also present adverse effects. For example, following weaker than expected inflation data last week, Canadian bond yields and the loonie fell.

“The move lower in Canadian bond yields pushed the spread between U.S. and Canadian two-year yields to an 11-year high, which leaves us wondering just how much higher [yield spreads] have to run,” says Richardson GMP.

Greater divergence between the Bank of Canada (BoC) and the Fed certainly won’t help the loonie. Odds of a July BoC hike are roughly 50-50, with more clarity expected as economic data is published.

In a financial markets report from early June, RBC reminds that monetary policy remains data dependent. “A number of upcoming releases will have to cooperate for rates to move higher on July 11,” the date of the next rate announcement, it says.

Upcoming data include GDP numbers and the BoC’s next business outlook survey (both on Friday).

“A positive signal from business on investment intentions and foreign demand—even in the face of trade uncertainty—would reinforce the BoC’s tightening bias,” says RBC.

Richardson GMP expects more loonie weakness ahead before levels reach “sentiment extremes.” Despite speculators remaining net short the loonie, current levels are far from the extremes seen in 2015 and 2017, says the report.

“It’s always risky being a contrarian, but being a contrarian in a market without extreme sentiment more often than not is just called being wrong,” says the report. “We’ll be keeping an eye on the derivatives market for any sudden large shifts.”

The firm further recommends an underweight in Canadian equities in favour of foreign equities—unhedged, to benefit from potential future currency weakness.

Read the full Richardson GMP and RBC reports.

Also read:

Where oil prices are headed, and why

Why the TSX recently rallied

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