Investor sentiment has been turning increasingly bearish against the Canadian dollar over the past month as sluggish oil prices and growing concerns of a major trade spat between Canada and the United States weigh on the loonie. The bearish outlook drove the Canadian currency to a more than 14-month low against its US counterpart last week, coming close to breaching the C$1.38 level.
The loonie was last trading near such levels in February 2016 when crude oil had just started its long recovery from the depths of a 12-year trough. Although the commodity has rebounded substantially since then, many analysts remain sceptical about the outlook for prices given that after four months of output restrictions by OPEC and some non-OPEC countries, the rebalancing of the oil market is nowhere near within sight.
Canada is a major producer of oil, with energy products accounting for 14% of the country’s exports. Apart from oil, Canada is also a major exporter of mineral products, including metals such as iron ore and copper. The recent weakness in metal prices hasn’t helped the loonie either.
Adding to the negative sentiment has been the recent friction between Canada and its southern neighbour over trade. After initially signalling the US only wanted to “tweak” its trade agreement with Canada, President Trump surprised many when he slapped import duties of up to 24% on Canadian softwood lumber products. The US administration cited unfair subsidies by the Canadian government to lumber producers as the reason for the tariffs. With the potential of the trade dispute extending to the dairy industry and possibly to the energy sector as well, the threat of a trade war between the two neighbours could cast a dark cloud over the loonie for some time as the renegotiation of the North American Free Trade Agreement (NAFTA) looms later this year.
But perhaps the biggest factor exasperating the Canadian dollar’s weakness in recent months is the diverging monetary policies between the US Federal Reserve and the Bank of Canada. The Fed looks set on raising rates in June for a second time this year as the US economy maintains a moderate pace of growth while the labour market continues to tighten. The BoC on the other hand is in no hurry to raise rates as the Canadian economy is still running at excess capacity and core inflation has been steadily falling over the past two years. The Bank has held rates at 0.5% since July 2015 and most economists are not expecting a rate hike until the first quarter of 2018.
However, with GDP growth rebounding sharply after the second quarter contraction in 2016 when growth was hurt by the wildfire in Canada’s oil sands, a rate hike could be nearer than anticipated. Growth is expected to pick up to an annualized rate of 3.8% in the first quarter according to the BoC, which revised up its full year forecast for 2017 from 2.3% to 2.5% in its April Monetary Policy report. Trade data released last week showed a sharp narrowing of Canada’s trade deficit in March due to a surge in exports. The housing market has also been performing strongly while the unemployment rate dipped to a nine-year low of 6.5% in April.
If the economic momentum continues to gather pace as expected and the trade dispute with the US doesn’t escalate further, the Canadian dollar’s bearish bias could run its course by the summer – especially once the Fed’s June rate hike is out of the way and OPEC/non-OPEC countries agree to extend the output deal beyond June, which would likely boost oil prices.