What is next for EURCAD?

Summary:

• Bank of Canada stays on course to continue hiking rates unlike the European Central Bank

• Canadian core inflation has basically reached the target

• A rate differential is expected to widen further in favour of the Loonie

• The bond market still gives abundant room for the EURCAD decline

• CAD is placed among the most undervalued G10 currencies according to the BIS data

• NAFTA talks remain a prime source of risks for the Canadian dollar

Over the course of recent months global central banks have moved in different directions in terms of monetary policy. While one group keeps monetary conditions remarkably loose (including BoJ, SNB or ECB) the other one (including Fed and BoC) continues lifting borrowing costs. Given the fact that interest rates are among prime drivers of currencies’ performance one may suppose that those currencies bearing higher interest rates could be more attractive in the eyes of investors. This is one of the reasons why the Canadian dollar could strengthen throughout the remainder of the year. On top of that we are presenting several more reasons behind such scenario.

As we have written above, the Bank of Canada stays comfortably on course to keep on increasing interest rates. This stance is reliably underpinned by price growth developments as Canada has pretty much reached the target of 2% inflation measuring not only with the headline but also the core CPI. At the same time, headline inflation has crossed 3% of late thereby striking the upper bound of a channel respected by the Canadian monetary authorities. Notice that during its September meeting the BoC admitted that higher than expected inflation seen in July was predominantly caused by a jump in the airfare component of the consumer price index. Either way, all three gauges of core inflation in Canada have been moving in the vicinity of the 2% objective recently providing the central bank with a sufficient reason to continue tightening monetary policy. The BoC also wrote in its September statement that the economy had been operating near capacity. In addition to inflation data other macroeconomic releases have been also solid despite the most recent disappointment on the labour market but keep in mind that Canadian employment data features quite high variability. As far as NAFTA is concerned the central bank said that it was monitoring closely the course of negotiations and other trade policy developments, and their impact on the inflation outlook.

Core inflation in Canada has been staying comfortably in the neighborhood of the BoC’s target. Source: Macrobond, XTB Research

In contrast to the Bank of Canada the European Central Bank is very unlikely to lift interest rates until through summer of the next year. While Canadian price growth has been steadily rising lately, core inflation in the Eurozone has remained well below the target suggesting that the quicker pace of headline inflation has been sparked chiefly by exogenous factors such as energy prices. That said the ECB was given no reasons to be more hawkish and nothing has changed since its meeting six weeks ago. Inflation remains moderate, PMIs and other soft indicators have turned down, GDP growth in the second quarter has undershot the central bank’s projection. All of these components signal no imminent pressure to begin hiking rates. Thus, while the ECB is expected to stay on hold at least until September 2019, one may easily imagine that the BoC could deliver subsequent two, three or maybe even four hikes within that time frame. This should lead to the yet wider rate differential in favour of the Canadian dollar. As for 11 September the 3-month interbank rate for CAD is 1.7% compared to the EUR rate of -0.4%. Having this in mind and assuming further rate increases over the oncoming quarters one may suppose that this could be enough to push the Loonie higher against the shared currency.

The 10Y yield differential keeps favouring the Canadian dollar over the euro. Given the fact that both central banks are expected to move in opposite directions this divergence could widen unless the pair moves down. Source: Bloomberg, XTB Research

The 10Y yield differential has been unequivocally pointing to the stronger Canadian dollar basically since the beginning of the past year. Over this period of time investors piled up the euro in anticipation of an impending switch in monetary policy albeit things have evolved since then. Inflation in Europe remains subdued unlike Canadian price growth therefore the Loonie seems to be in a position to outperform the euro in the months to come. Do note that buying the CAD against the common currency looks attractive from a valuation point of view as showed at the chart below. Of course, the US dollar remains much more overvalued (compared to the euro) but keep in mind that the Federal Reserve is widely expected to pursue its monetary tightening hence the rate differential should more or less stay unchanged with the CAD - this is why buying CAD against EUR appears to offer a more profitable investment opportunity.

The Canadian dollar was ranked second most undervalued currency according to BIS data at the end of July. Source: Bloomberg, XTB Research

Let us also point out that Z-Score depicted at the above chart shows a number of standard deviations from the 10Y average of REER index of each currency. What are risks surrounding the Canadian dollar? Basically we may come down all these risks to trade negotiations with the United States. Given the fact that the US is a major trade partner for Canada it is obvious that an ultimate deal on NAFTA will have far-reaching consequences for Canadian trade and thereby the entire economy. Let us notice that a dramatic decline of the Canada’s trade balance that took place between 2002 and 2012 (from roughly 10% to 0% of GDP) was caused mainly throughout a declining trade surplus with the US (among goods being responsible for such the decline were passenger cars, light trucks and parts). Meanwhile, the most recent remarks from both sides signal that a breakthrough in negotiations is at hand, and if so, the CAD would get rid of a prime source of risk.

Looking at the weekly time frame of the EURCAD one may notice that the pair has recently run into a resistance placed in the vicinity of 1.5220. This level is also supported by the 38.2% retracement of the whole swing taking place between February 2017 and March 2018. Assuming that risks related to NAFTA do not materialize and both the US and Canada will be able to sign off on a revamped deal, it could be CAD supportive. This in connection with subsequent rate hikes in Canada and relative oil prices stability could drive the cross lower. Therefore, we are recommending to go short at a market price with a stop order at 1.54 and a take profit order placed at 1.45. Source: xStation5