Analysts foresee a continuing loonie weakness, as currency is hit from multiple angles

The Canadian dollar has taken a drubbing in recent days, with a hawkish turn from the U.S. Federal Reserve alongside tariff threats and political turbulence in Ottawa sending the loonie below the symbolic 70-cent mark.

 

Canada’s currency regained some ground on Thursday, after a sharp sell-off the day before. However, analysts warn that there are few near-term catalysts for a significant turnaround for the loonie – with the potential for further declines if U.S. president-elect Donald Trump follows through on his tariff threats.

 

The Canadian dollar has been losing ground against the U.S. dollar for several months, falling from around 74.5 US cents in late September to around 69.5 cents on Thursday. This is only the third time in the past two decades the loonie has traded below the 70-cent mark.

 

This is more a story of U.S. dollar strength than Canadian dollar weakness. The greenback has gained ground against most major currencies in anticipation of Mr. Trump’s return to the White House promising deregulation, tax cuts and tariffs – a cocktail that will juice economic growth, at least in the near term, and fuel inflation. The loonie has largely held its ground against other currencies.

“If the Canadian dollar recovers, it’s going to be more likely because the U.S. dollar weakens for some reason. Now that could be that Trump wakes up one morning and decides he doesn’t want a stronger dollar,” Shaun Osborne, chief currency strategist at Bank of Nova Scotia, said in an interview.

 

The broader flow of investment into the U.S. has been compounded by the growing gap between the Bank of Canada and the U.S. Federal Reserve on interest rates.

 

Canada’s central bank has cut interest rates more aggressively than the Fed – including by another half percentage point last week – in response to slower economic growth and a faster drop in inflation.

 

The divergence sharpened on Wednesday when the Fed cut by a quarter-point and signalled fewer cuts next year than markets expected. This sent the Canadian dollar down nearly a full percentage point against the U.S. dollar.

 

“You have to look back to the late nineties for the last time that we had such a wide gap between U.S. and Canadian interest rates. So that will continue to weigh on the currency until we see that gap start to close,” Lorne Gavsie, head of macro and foreign exchange strategy at CI Global Asset Management, said in an interview.

 

Mr. Trump’s threat to put a 25-per-cent tariff on all Canadian imports is also hampering the currency, although markets haven’t fully priced in the risk to the Canadian economy that tariffs at this level would pose, Mr. Gavsie said.

 

“There’s still this view that this is a negotiation tactic, not necessarily something that will absolutely come to fruition. But if it were to, I would argue that there’s still a decent amount of Canadian dollar weakness to materialize,” he said.

 

Countries that impose tariffs tend to see their currencies appreciate while countries that are subject to tariffs see their currencies depreciate. This is because the exchange rate acts as an adjustment mechanism to keep the balance of trade between two countries roughly the same before and after the tariff, said Olivier Jeanne, an economics professor at Johns Hopkins University in Baltimore, who studies exchange rates.

 

“As a rule of thumb, if the U.S. imposes a 10-per-cent tariff on all its imports, that would appreciate the [U.S.] dollar by maybe 5 per cent,” he said in an interview. “If the tariffs were especially targeted on Canadian exports, then that would appreciate the dollar less, but that would certainly depreciate the Canadian dollar.”

 

The uncertainty surrounding tariffs has not been helped by the drama in Ottawa, where Chrystia Freeland resigned as finance minister on Monday only hours before she was supposed to deliver the fall economic statement.

 

Currency markets tend to look past the cut and thrust of politics and focus on macroeconomic variables, said Mr. Osborne of Scotiabank. “Even when Bill Morneau left quite unceremoniously last time, it was a bit of a shrug for the Canadian dollar,” he said of the former Liberal finance minister.

 

This time, however, there was more of a reaction to Ms. Freeland’s departure, given the imminent threat of tariffs. “We’re 30 odd days away from the inauguration now, and this just leaves a big question mark about who’s driving the bus here, and what is the response actually going to be.”

Mr. Osborne said he expects the Canadian dollar to hover around this level for the next year, with some potential upside if there is a pick-up in global commodity prices, and significant downside risk if Mr. Trump proceeds with his trade war.

 

So far, the Bank of Canada has played down the weakening loonie, which will add to inflation by pushing up the price of imported goods.

 

Kyle Dahms, an economist at National Bank of Canada, said that the pass through of currency depreciation into general Consumer Price Index inflation tends to be muted, as many importers have hedged their exposure to the U.S. dollar. That said, some Canadians will certainly feel the weaker loonie.

 

“If you’re making Canadian wages in Canadian dollars and you’re spending your money in Canada, for the most part, I don’t think it’s a pressing issue,” Mr. Dahms said in an interview.

 

“But if you go between Canada and the U.S., that’s probably something on your mind. And for people who spend half the year in the U.S., this is certainly going to impact their bottom line.”

 

 

 

 

This article was first reported by The Globe and Mail