Is it Crazy to Like the Loonie?

The Canadian dollar is falling for a fifth consecutive session and seventh in the past eight.  It is the weakest of the majors here in June, off a little more than 2.5%.  The speed of its sell-off has pushed the US dollar above the upper Bollinger Band (~CAD1.3265).  It is stretched, but the technical indicators like the RSI, MACDs, and Stochastics are not indicating an imminent top.  

Nevertheless, we suspect the market is exaggerating Canada’s negatives.   It begins with NAFTA.  Contrary to the talk that circulated before the recent G7 summit, the US has not withdrawn from the negotiations or agreement.  Indeed, US President Trump cited progress in the talks yesterday.   

Apparently, the main sticking point is the US demand for a sunset clause, which would end the pact in five years without a new affirmation by all three members.  Canada and Mexico object.  They see it running counter to the effort to encourage businesses to take a long-term view and help economically integrate the continent.  

The Bank of Canada is the next major central bank that may hike interest rates.  The meeting is on July 11.  The Bank has indicated two things.  First, NAFTA and trade more broadly are important sources of uncertainty.  Second, it wants to continue to gradually remove some accommodation; i.e., raise rates.  

Trade uncertainty has not been lifted, but, at least on the margins, it is slackened.  A US unilateral withdrawal from NAFTA is less imminent than it may have seen a couple weeks ago.  Talk in Washington suggests that this is the one concession that presidential adviser Kudlow managed to secure.   The US has opened an investigation into auto imports on national security grounds.  Tariffs on autos, which Trump has threatened, would hurt Canada without an exemption.  However, the investigation and rest of the process could take the better part of the next 12 months.  

While the US and Canada protect different industries in different ways, and the NAFTA agreement is data, investors need to look past the heated rhetoric.  There is cross-border shopping, but Canadians that shop in the US pay tax at the point of purchase.  The credit card companies (but not necessarily cyber currencies) collect the sales tax, which in some countries is called a VAT, which is levied on purchases of goods whether or not they made domestically.  Meanwhile,  many American households purchase cheaper medicines in Canada than available in the US.    The Trans-Pacific Partnership, which the US withdrew from last year, would have modernized NAFTA.  

The Canadian dollar has fallen the odds of a Bank of Canada rate hike receded.  A week ago, the OIS implied a three-quarters chance of a hike on July 11.  Now it is closer to two-thirds.  Further out on the curve, the US two-year premium over Canada pushed above 70 bp for the first time since before the financial crisis.  The 10-year differential is near 73 bp.  Last year’s peak was about ten basis points higher.  In late 2015, it peaked just shy of 90 bp, which is the most since at least the last 1980s (the extent of the data easily available).  

In the medium-term, the policy mix in the US (tighter monetary policy and looser fiscal policy) is more aggressive than Canada’s and will lead to a stronger US dollar.   However, near-term, we suspect it has gone up too far too fast against the Canadian dollar.  The market may be underestimating the risk of a Bank of Canada rate hike and a recovery in oil prices.  The CAD1.33 area which the US dollar is testing today corresponds to almost $0.75, which is a level that may be attractive to Canadian exporters.  On the downside, our initial target is around CAD1.3150.  


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