Fundamental Forecast for Canadian Dollar: Neutral

- Canadian Dollar stands to take over the Aussie dollar’s old role with rate hikes and unmatched growth
- USD/CAD may have breached a long-term trend; but a reversal pattern could stall its advance

It may not have been so easy to define the Canadian dollar’s source of strength over the past year or so (hint: it is not a simple connection to crude oil); but we should have no trouble in determining where its next fundamental drive will come from over the coming week. On deck for the ‘loonie’ over the coming week are a critical Bank of Canada rate decision and the long overdue release of first quarter GDP. Given the consensus forecast for both events, the currency may find itself taking over the role that the Australian dollar has so clearly coveted since the global economic recovery took hold last year. If indeed the affair goes off as expected, the Canadian dollar may find itself with a growth advantage that no other major economy can match along with interest rate potential that is surely not yet fully priced in. On the other hand, it is clear that the market is already heavily biased on the outcome of these events. Disappointments would very likely illicit more of a reaction from currency traders than merely meeting bullish expectations. What’s more, it should not be forgotten that the currency has already appreciated significantly alongside its commodity currency counterparts. Will this moderate further gains or swamp tangible fundamentals with current changes in sentiment?

For the traditional fundamental trader (who likes to see his or her potential driver ahead of time), the first thing to be concerned about its Monday’s release of the first quarter growth report. We have already seen the first January and February monthly readings of economic activity; so we have a feeling for how the broader period may fair. And, given the relatively good performance over the first two months of the year, the 5.9 percent forecasted annualized pace of growth does not seem unreasonable. For context, this would be the fastest pace of growth in over 10-years and it would confirm speculation that the Canadian economy will outpace its global counterparts and is better positioned should there be a second slump in global activity levels going forward. This can prove a crucial source of strength for the currency because relative growth will rise in importance for long-term capital flows going forward. Economic activity is the backdrop of expected return on a nation’s assets; and a performance of this magnitude coupled with the knowledge that Canada was able to weather recession and financial crisis much better than its peers these past years will no doubt peak investors interests.

However, for returns, growth is only one component of a benchmark. Interest rates are another factor. According to overnight index swaps from Credit Suisse, the market is pricing in a 68 percent probability that the BoC will hike on Tuesday. That is perhaps lowballing the potential given the hawkish turn the group has taken recently and the OECD’s recommendations that it should start removing accommodation immediately. What’s more, the forecast for nearly six quarter point interest rate hikes over the coming 12 months has recently been reduced to approximately four. With this decision, we will likely see forecasts take a dramatic turn for the better or worse depending on the outcome.

It is important to watch both of these scheduled events and evaluate their influence again the backdrop of risk appetite. As it stands, the Canadian dollar has a significant risk premium and relatively little fundamental swagger to back it up. The loonie does not have the yield that its Aussie and kiwi counterparts maintain. Growth is running hot; but so the US economy. To find the ability to further appreciate (especially in the face of risk aversion), the currency needs to establish a high level of safety and potential return. This would be a unique combination that no other economy can match (Australia is fading). Yet, should these fundamental highlights not come to fruition, it could prove the Canadian dollar’s undoing.

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