Photographer: Brent Lewin/Bloomberg

Signs Are Flashing Loonie Surge Has Gone Too Far, Too Fast

  • Canadian dollar has seen strong gains since start of year
  • Risks seen building, including possible trade talks with U.S.

Traders may think they are smarter than central bankers, but when Bank of Canada Governor Stephen Poloz says "uncertainty" a dozen times in a speech, they should listen.

The loonie has gained about 4 percent against the U.S. dollar since touching a 10-month low at the end of last year amid higher oil prices and a weaker greenback. But looming are possible U.S. trade talks, a weak economic recovery and a potentially dovish central bank. These fundamental factors, along with technical indicators, point to a potential reverse.

The currency also has so far mostly escaped Donald Trump’s trade wrath even though he has lashed out at China, Japan, Germany and Mexico. Those countries, along with Canada, make up America’s top five trade deficits.

One of the barriers to further Canadian dollar gains is a gap in monetary policy. The Federal Reserve is expected raise rates, while the Bank of Canada is seen on hold. Investors should continue to take advantage of the carry trade, widening the spread between the sovereign two-year yields and pressuring the currency.

Bank of Canada Governor Stephen Poloz used the word "uncertainty" 12 times in his speech Tuesday in reference to the challenges of policy making, again flagging the risks tied to renegotiating Nafta. He also said the loonie has risen too soon amid "persistent excess capacity" in the economy and with inflation holding below the bank’s 2 percent target. Growth is seen rising to 1.9 percent this year partly on expectations of rising exports, but there are risks.

The big risk is Trump. The president wants to renegotiate the North American Free Trade Agreement to try to bring back jobs to the U.S. Canada is America’s second-largest trading partner and runs its fifth largest deficit.

Oil is the country’s largest export and some analysts see a rebound. But oil exports may be capped if prices are held down as shale production returns. Cars and related products, a sector that has been a Trump target, make up the second-largest trade sector.

The Canadian dollar could escape with only a few knocks if oil rises, if the economy sees a stronger recovery and if the government negotiates a tolerable trade deal despite rising exports. But those are big ifs.

"The CAD has performed remarkably well supported by higher oil prices, but all good things do eventually come to an end," Deutsche Bank AG foreign-exchange strategist Sebastian Galy said by e-mail.

Technicals

  • USD/CAD has tested and held the base of trading-envelope support at 1.2964, a level which coincides with 1.3000 quadruple bottom support since last September.
  • Elliott Wave and Fibonacci analysis form a similar pattern; both suggest CAD will extend near-term gains only to form a base, leading to longer-term CAD weakness.
  • The Elliott Wave study is close to completing the second wave, which would extend U.S. dollar losses toward 1.2896. The pair will enter the third wave after it bottoms, which would be a higher trend for the U.S. dollar.
  • Fibonacci support is seen at 1.2987, the 23.6 percent retracement from January highs to May lows. If the U.S. dollar resumes an uptrend, the pair could test toward resistance at 1.3312 and then 50 percent retracement at 1.3575

A weaker Canadian dollar could be good for the economy and help it transition away from a dependence on energy exports. Investors should listen up.

NOTE: Vincent Cignarella is an FX strategist who writes for Bloomberg. The observations he makes are his own and are not intended as investment advice.

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