Fundamental Forecast for Canadian Dollar: Bearish

The Canadian dollar continued to weaken against its U.S. counterpart, with the USD/CAD rallying to a fresh monthly high of 0.9792, and loonie may depreciate further in the week ahead as interest rate expectations falter. As the headline reading for inflation holds steady at an annualized 3.3%, the Bank of Canada will certainly keep the benchmark interest rate at 1.00% in May, and Governor Mark Carney is likely to reiterate his pledge to ‘carefully consider’ future rate hikes given the substantial margin of slack within the real economy.

Although the BoC sees price growth holding above 3% in the second-quarter, Mr. Carney argued that the recent developments “supported the Bank’s near-term outlook,” and said inflation will fall back towards 2% by the middle of 2012 while delivering a speech earlier this week. At the same time, the central bank head warned exports could be dampened “for some time” given the slow recovery in the U.S., Canada’s largest trading partner, and saw a risk for a further appreciation in the local currency, which would add additional downward pressures on the real economy. The recent comments made by Governor Carey suggest that the BoC will carry its wait-and-see approach into the second-half of the year, and the Canadian dollar may face additional headwinds over the near-term as interest rate expectations deteriorate. According to Credit Suisse overnight index swaps, investors now see borrowing costs in Canada increasing by nearly 75bp over the next 12-months, which compares with projections for a 100bp rise at the beginning of May, and the central bank may look to support the real economy throughout the third-quarter as the fundamental outlook for the global economy remains clouded with high uncertainty.

As the near-term rebound in the USD/CAD gradually gathers pace, with the exchange rate pushing above the 100-Day moving average for the first time since November, there’s certainly a risk that the pair could approach the 78.6% Fibonacci retracement from the 2007 low to the 2009 high around 0.9900 in the week ahead as currency traders scale back their appetite for risk. Beyond the 78.6% Fib, we will need to see a test of the 200-Day SMA (0.9989) to confirm a bullish trend in the USD/CAD, and the dollar-loonie may threaten the downward trending channel that was carried over from back in 2009 as it appears to have carved out a bottom in May.

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