Our last outlook on the Canadian dollar remains largely intact two-months into 2021. Our expectation of the loonie rallying on a structural basis this year has generally occurred thus far, despite the distribution of vaccines in Canada not living up to the expectations set by the level of pre-orders made in Q4 2020. The loonie’s rally has instead been driven by a rise in oil prices, expectations of increased fiscal stimulus in the US, and a hawkish message from the Bank of Canada. To reflect these developments, our forecasts have only been subject to minor revisions. We have lowered our USDCAD forecast for February from 1.28 to 1.27, while maintaining our longer-term views for the remainder of the year. Owing to the elapse in time, our February forecasts that were submitted at the end of January, now include the first month of 2022 in their coverage. Risks to our outlook remain, and tilt to the upside in the short-term. This is reflective of the US dollar remaining much more resilient than most expected, with FX markets opting to find shelter in the greenback amid an environment of vaccine delays and potentially reduced efficacy. However, in 21H2, we view the risks to our USDCAD forecasts as tilted to the downside, but the balance of risks over this horizon is conditional on a broad and stable reopening of major economies.
Monex Canada’s February 2021 USDCAD forecasts
CANADA’S LACK OF VACCINE DISTRIBUTION REMAINS A HEADWIND IN THE SHORT-RUN
Since our last CAD outlook, data released from Canada has been mixed. Sentiment gauges, PMIs and other soft data points have remained robust. Meanwhile, more timely hard data such as January’s labor force survey visibly highlight the pressure the Canadian economy remains under during the latest lockdown measures. Overall, current activity indices, which assess more timely data points to give flash estimates of economic activity prior to the official GDP release, show Canada’s economy contracting in the early part of Q1. The Bank of Canada confirmed this assertion in their January MPR where they forecast GDP to decline by 2.5% in Q1 in annualised terms.
Bank of Canada’s latest GDP and CPI projections from the January MPR show the inflation target not being reached until 2023, while GDP growth is expected to be slower this year
October’s MPR forecasts are included in parentheses ()
While new cases have slowed under the latest lockdown measures, allowing a marginal easing of restrictions in parts of Ontario and Quebec over the last week, a broader re-opening of the economy rests in the fate of vaccine distribution. While the Bank of Canada assumes herd immunity by the end of 2021 in its latest growth forecasts, which is six months earlier than assumed back in October 2020’s MPR, vaccine distribution in Canada has underwhelmed considering the elevated number of pre-ordered vaccines back in Q4 2020. Ultimately, this has resulted in expectations of Canada’s economic recovery this year being trimmed. The Bank of Canada highlighted this when it downgraded its growth projection from 4.2% to 4.0% for 2020. While Prime Minister Trudeau has pledged that Canada will receive some 6m vaccines by the end of Q1, enough to vaccinate around 15% of the population without considering second doses, the current rate of vaccine administration remains a significant headwind to the recovery.
Canada’s rate of vaccine distribution has been sluggish compared to peers despite elevated amount of pre-orders
Assuming a constant growth rate of vaccines administered, Canada is on track to vaccinate only 10% of its population with at least the first dose by the end of Q1. This is substantially lower than the UK and US
ADDITIONAL NEAR-TERM RISKS ARE PRESENTED BY THE OVERALL RISK ENVIRONMENT, WITH USDCAD TRACKING THE BROAD US DOLLAR CLOSELY AT THE START OF THE YEAR
Additional near-term risks to our bullish USDCAD calls aren’t just focused domestically with the distribution of vaccines, but the overall market environment for risk too. USDCAD has tracked the broad US dollar closely in the first quarter of this year, with FX markets focusing on the overall risk environment and global growth conditions as much as domestic drivers. Headlines of further vaccine delays or a reduction in their efficacy has roiled FX markets and propped up the dollar so far this year, with the US economy expected to outperform peers especially with an additional $1.9trn worth of stimulus coming down the pipeline. While the path to reopening remains unclear in most major economies, the risk environment continues to be tentative and subject to extreme headline risk. Until lockdown measures are eased in G7 economies, the broad risk environment is just one headline away from the US dollar taking another leg higher, thus adding additional upside risks to our near-term USDCAD forecasts.
USDCAD tracks the broad US dollar DXY index in the first part of the year as the risk climate remains tentative
DESPITE THE NEAR-TERM RISKS, THE BOC SIGNALLED ITS INTENTIONS TO TAPER QE AT THE END OF THE YEAR, PRESENTING THE BASIS FOR A LONGER-TERM RALLY IN THE LOONIE
The Bank of Canada’s January meeting struck cautiously optimistic tones regarding the economic recovery, despite the near-term downgrades to growth projections.
We are inclined to agree with the Bank’s assessment of the recovery, given the elevated level of household deposits, rising equity and home prices producing a positive wealth effect, strong level of fiscal support, and the recent rally in oil prices.
However, much of the positive outlook depends on the distribution of vaccines and how effective they are in allowing the economy to reopen on a long-term basis. Our forecasts anticipate the path to reopening the economy on a broad basis will be made clear by officials at some point in Q2. Despite this, the mere presence of vaccines and the decline in the number of new cases is allowing the Canadian economy to reopen somewhat, offsetting the economic impact of tighter measures in the early part of Q1. This will come as a welcome development to the Bank of Canada, with the positive surprise to the growth outlook being reflected in the loonie’s price action of late.
Over the coming months, the further easing of restrictions will allow the recovery to pick up in pace. The positive tailwinds to the recovery, outlined above, should result in the realisation of the BoC’s annual growth projection of 4%, with the speed of the recovery being most rapid during the initial reopening phases. Based on this, and the Bank’s decision to defer from “mini rate cuts” in response to January’s near-term risks, we believe the BoC will taper its asset purchases in Q4. This is much earlier than our expectation of QE tapering by the Fed, leading to expectations of policy normalisation favouring our base case of CAD appreciation.
Recent lockdowns in Canada push US-Canada 2Y yield differential lower, but earlier tapering by BoC could push yield spread further in favour of CAD unless BoC intervene further
One risk to this view of earlier policy normalisation by the BoC is that in the 5-year review, due to be completed this year, the Canadian central bank joins the Fed in adopting an average inflation target.
This would reinforce the BoC’s message that rates will remain at the lower bound until 2023, reducing the rate differential generated by the earlier tapering of their QE programme. However, on average, the risks to our USDCAD forecast over the medium-term remain tilted to the downside given the factors in play that could cause a faster economic recovery than the BoC anticipates at present.
Author: Simon Harvey, Senior FX Market Analyst