USDCAD: What to expect in the following year?

Summary:

• CAD looks highly undervalued against the US dollar

• Canadian dollar could be out of the woods when it comes to the last oil price slide

• New NAFTA (USMCA) is done for now reducing some risks

• Short-term rates point to overvaluation of the USDCAD

• BoC expected to continue hiking rates as evidenced by the most recent hawkish statement, core inflation stays on target

• USDCAD approaches crucial resistance, further upside limited

The upcoming year could be important from a monetary policy’s point of view as it may bring some turning points. First of all, the European Central Bank is widely expected to begin monetary tightening in the second half of 2019. At the same time other central banks, including the Federal Reserve and the Bank of Canada, are forecast to keep on raising borrowing costs. However, as global economic growth begins stuttering, some doubts concerning the future course of monetary policy have arisen. Today we are outlining the outlook for the Canadian dollar taking into account aspects beyond monetary policy.

The USDCAD looks overvalued based on the TWI REER approach, further upside could be limited. Source: Macrobond, XTB Research

The US dollar is expensive - such conclusions can be drawn when we take a look at the TWI REER measure. However, analysing the currency market it could be useful to focus on two currencies making up the pair. In this case we may notice that the USDCAD is trading at the demanding levels with the difference between standard deviations from the 20Y average in each currency crossing 2. It means that it is the third highest valuation since the US dollar rally began in mid-2014. Nonetheless, unlike the two previous spikes (the green line at the chart below), this time it’s all about the USD TWI REER. It has come at a time of declining oil prices suggesting the Loonie has been fairly resilient to unfavourable developments from the commodity market.

Oil price slide and a huge discount in WCS grade

The WTI/WCS spread has spiked of late but the worst could be already behind us. Source: Bloomberg, XTB Research

The oil market plays an important role for the Canadian economy as the country is placed among the world’s largest producers. Therefore, it is not surprising that the latest 30% slide in oil prices could not act in favour of GDP growth and the local currency as well. However, one needs to be aware that for Canada other grade of crude matters - Western Canadian Select (WCS), hence economists covering the Canadian economy focus on a price difference between WCS and WTI - the lower spread, the less Canadian economy is losing compared to US producers. The WCS grade is sold at a discount to WTI grade reflecting quality issues as well as transportation costs from Alberta, Canada, to refineries in the United States. Due to the lack of a pipeline the cost of transport to the US is substantial and therefore Canada needs to sell its crude with a huge discount. All it means that the Canadian economy is losing around $100 million each day due to a high discount. Of course, transportation issues will not be solved in the nearest future because building a pipeline takes a lot of time, hence Canada has decided to deliver its crude to the US via railway. Having said that, the Canadian dollar did not decline that much at a time when WTI prices plunged by 30%. During roughly 6 weeks the CAD slid a bit more than 3% while the Norwegian krone fell over 5% - it shows that the latter seems to be more sensitive to oil price fluctuations. Given such a steep and quick decline in oil prices we think that a tipping point could be around the corner. We also assume that the OPEC will take some steps to trim production when it meets at the beginning of December.

USMCA-related risks have abated

The Canadian dollar (and the Mexican peso) were burdened with some downside risks related to NAFTA negotiations. However, this topic seems to be done for now taking these risks off the Loonie. Let’s recall that months-long negotiations ended with a new free trade agreement called USMCA (The United States-Mexico-Canada Agreement) on September 30. The deal has not been signed yet but the countries are expected to do so on November 30. Provisions of the agreement touch many areas. For example, Canada agreed to raise the duty-free limit on purchases from the US to $150 from the previous level of $20; cars having at least 75% of components being made in the US, Canada or Mexico have been allowed to be sold with zero tariffs; US dairy farmers have been given greater access to the Canadian market. By and large, the new trade agreement looks pretty similar to the old one but from a market’s point of view the most important is that it could no longer influence sentiment.

Short-term rates support the stronger CAD

The short-term interest rate market points to room for the USDCAD to correct its recent increase. Source: Bloomberg, XTB Research

At the chart above we may notice that the worse performance of the USDCAD occurred at the beginning of October when oil prices began falling. Since then the pair has climbed approximately 550 pips but this move has not been supported by the short-term interest market. Instead, the FRA 9x12 spread has barely moved suggesting that the latest swing could have been overreacted being steered mainly by declining oil prices. This relationship has worked quite successfully so far this year increasing the odds that this time could be similar. If so, the pair could head lower even below 1.30. In addition, the December Fed meeting could be really important in assessing the broader outlook for monetary policy in the US and we see some downside risks for the US dollar in the aftermath.

BoC should continue tightening

Various measures of core inflation in Canada keep hovering around the BoC’s target. Source: Macrobond, XTB Research

Finally, let’s take a look at the macroeconomic prospects for the Canadian economy. Although recent releases have been mixed, the overall tone remains upbeat implying that the Bank of Canada ought to keep on tightening monetary conditions next year. Note that in its latest statement released in October the Bank of Canada tightened up its rhetoric writing that more rate hikes would be needed to achieve the inflation target. On top of that, the communique admitted that the USMCA deal “would reduce trade policy uncertainty in North America, which had been an important curb on business confidence and investment.” In assessing an impact of US-China trade tensions the Canadian central bank wrote then that the net effect included in the projections was negative, but small suggesting that the Canada’s economy is unlikely, according to the central bank’s estimates, to suffer substantially from trade frictions. Looking elsewhere we may see the very tight labour market (for example, the number of firms with vacancies they are not able to fill has already increased well above the pre-crisis levels) implying that wage growth should be rising gradually.

Technical outlook

Technically the pair has been trading within the ascending channel since July 2017. The latest swing to the upside coincided with the slide in oil prices and has seen the pair bouncing off the lower bound of the mentioned linear pattern. While the pair keeps rising, it may soon run into an obstacle - the upper boundary of the channel (ca. 1.3520). This level could again serve as a turning point, pushing the price back toward the middle of range trading. Having this in mind we recommend going short at a limit price of 1.35, a target of 1.2750 followed by 1.22 and a stop order at 1.38. Source: xStation5