Loonie 6-Month Lead at Risk as First G-7 Rate Gain Looms

Bank of Canada Governor Mark Carney
Mark Carney, governor of the Bank of Canada. Photographer: Tomohiro Ohsumi/Bloomberg

The Canadian dollar’s reign as the best-performing major currency over the past six months is in jeopardy as rising consumer debt loads collide with plans by Bank of Canada Governor Mark Carney to increase interest rates.

While international investors typically favor currencies with high rates for the potential for greater returns, traders are signaling that in Canada it would do little more than damage an economy underpinned by debt. Household borrowing was 152.9 percent of disposable income at the end of last year, climbing from about 135 percent in 2007 and exceeding the U.S.’s 145 percent, according to data compiled by Bloomberg.

“So much of Canadian growth is led by domestic demand and that domestic demand is led by consumer spending and consumer spending is linked to expanded leverage,” Shahab Jalinoos, a senior currency strategist in Stamford Connecticut at UBS AG, said in an interview April 24.

Strategists predict the currency will depreciate to parity with the U.S. dollar by March even as Carney reiterated last week that increasing rates may be “appropriate” as the economy moves closer to full recovery. Options traders are paying the highest premiums since January for protection against the so-called loonie weakening amid forecasts for higher volatility, which tends to dim the appeal of currencies. UBS sees it falling to C$1.05 per U.S. dollar by year-end from 98.01 cents.

Rate Reaction

The last time the Bank of Canada lifted borrowing costs was in 2010, when it raised its target overnight lending rate to the current 1 percent from 0.25 percent in three steps between June and September. The nation’s currency depreciated 7.46 percent in that period against nine-developed nation counterparts as measured by the Bloomberg Correlation-Weighted Indexes.

At its last monetary policy meeting on April 17 the Bank of Canada said growth and inflation will be faster than earlier forecast. Inflation, which was 2.6 percent in February, has exceeded its 2 percent goal for 15 straight months before dropping to 1.9 percent last month.

Traders are pricing in a 66 percent chance that rates will rise by the bank’s Sept. 5 meeting, making it the first Group of Seven nation to tighten monetary policy this year, based on overnight index swaps. Odds fell from 75 percent on April 27 after Statistics Canada reported today that Canada’s gross domestic product unexpectedly contracted 0.2 percent in February. Derivatives showed traders are still expecting about 0.33 percentage point of increases by year-end.

Relative Growth

Carney’s announcement triggered a rally in the loonie, named for the aquatic bird depicted on the one-dollar coin, on speculation yield-starved international investors will continue to seek out the nation’s assets. It was at 98.84 cents per U.S. dollar at 12:10 p.m. New York time, after strengthening to 98.04 cents last week, from 99.24 cents on April 20 and 99.97 cents on April 13.

“The key risks” to Carney’s “sunnier stance lie in domestic private spending, particularly by households,” Avery Shenfeld, the chief economist at CIBC World Markets in Toronto, said in an April 17 note.

Consumers, propelled by a booming housing market, account for about two-thirds of an economy that the central bank forecasts will expand 2.4 percent this year. That’s better than the 1.27 percent estimated growth for the Group-of-10 nations, according to the median estimate of economists in separate surveys by Bloomberg News.

Rising home prices led to a 35 percent increase in residential mortgage credit in the past five years through October 2011, or an average rate of 7 percent a year, according to Bank of Canada data. The amount of outstanding mortgages rose to C$1.08 trillion as of August, the latest figures from the Canadian Association of Accredited Mortgage Professionals show.

‘Vulnerabilities Exposed’

The average home price is about 4.75 times income, compared with a historical average of 3.5 times, Carney told the House of Commons Finance Committee April 24 in Ottawa.

“As soon as something happens to challenge the ability of that country to keep building up leverage, like a rate hike, you find the vulnerabilities are exposed and then the currencies sell off quite dramatically,” Jalinoos said.

A week after the Bank of Canada’s April 17 meeting, government data showed retail sales unexpectedly declined for the first time in seven months in February, led by a drop in purchases of new cars.

Sales fell 0.2 percent to C$38.9 billion ($39.7 billion), according to Ottawa-based Statistics Canada, which cut its estimates of the increase in January to 0.2 percent from 0.5 percent. Economists surveyed by Bloomberg News forecast a 0.1 percent gain in February, based on the median of 23 projections.

Exceeding Parity

Canada’s currency rose beyond parity with the U.S. in 2007 for the first time in three decades, touching a record 90.58 cents in November 2007 after rallying from C$1.62 in 2002 on demand for commodities. Raw materials such as lumber, wheat, oil, gold, nickel and zinc account for about half of Canada’s export revenue.

Crude, the largest export, will rise to $107 a barrel in the second half of the year, from $104.93 last week and 2011’s low of $74.95 in October, according to the median forecast of 30 economists in a Bloomberg News survey.

The loonie gained 4.2 percent in the past six months, the most of any major currency based on Bloomberg Correlation-Weighted Indexes. Hedge funds and other large speculators increased bets the currency will gain to the most since May 2011 following the Bank of Canada meeting.

The difference in the number of wagers by hedge funds and other large speculators on an advance compared with those on a drop -- so-called net longs -- was 44,224 on April 24, up from 38,028 a week earlier, figures from the Washington-based Commodity Futures Trading Commission show.

Relative Yields

High relative yields are drawing foreign investors, who purchased a net C$13.7 billion of Canadian bonds in February, the most since May 2010, Statistics Canada said April 16.

Government notes due in one to three years yield about 1.4 percent on average, more than the 0.94 percent for similar-maturity sovereign debt globally, according to Bank of America Merrill Lynch indexes. At the end of December, they yielded 0.98 percent, 0.075 percentage point less than the global index.

“Canadian dollar strength comes from strong capital inflows,” David Grad, a foreign-exchange strategist at Bank of America Corp. in New York, said in a telephone interview April 24. That almost makes the currency more vulnerable in the event of capital flight, he said.

The odds of that happening are rising with expected price swings in currencies the lowest since 2007, according to Shaun Osborne, the chief currency strategist at Toronto-Dominion Bank in Toronto. The JPMorgan Global FX Volatility Index tumbled to 8.88 last week from more than 16 in September.

‘Fragile Place’

“There’s a bit of complacency creeping into the markets and one bit of bad news we could see risk sentiment trip up,” Osborne said April 26. “The global economy is still in a very fragile place. There is potential for another cent but 97 to 98 cents looks really quite rich.”

The median estimate of about 40 economists and strategists is for Canada’s dollar to trade at 98 cents by year-end and at $1 by March 31. Option traders are paying more for protection against a decline in the Canadian dollar. The premium for the right to buy the U.S. currency against the loonie in three months, compared to the right to sell it, reached 2 percentage points this month, up from this year’s low of 1.35 percentage points in January.

“The importance of Bank of Canada monetary policy on the currency gets overstated,” Greg Anderson, the North American head of G-10 currency strategy at Citigroup Inc. in New York, said in an interview April 26. The firm sees the loonie unchanged at 98 cents by year-end.

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