Loonie’s Worst Seen Behind as Bulls Embrace Surplus
Traders are betting the Canadian dollar fell too far, too fast in its worst start to a year in more than four decades, as rising commodities prices and a forecast budget surplus damp speculation for interest-rate cuts.
The cost to insure against the loonie weakening further dropped to the lowest in three years, and analysts are downgrading the currency at the slowest pace since October, when the Bank of Canada began a policy shift that sent it tumbling to a 4 1/2-year low of C$1.1224 per U.S. dollar on Jan. 31. Canada’s dollar has gained more than 2 percent since then to C$1.0981, and is forecast to end the first quarter at C$1.10, according to the median estimate in a Bloomberg survey of 64 respondents.
Finance Minister Jim Flaherty presented a budget this week that pledged a return to surplus in 2015, bolstering the nation’s top AAA credit rating and easing speculation the central bank will need to step in to support the economy. The price of crude oil, Canada’s largest export, climbed to the highest level in four months yesterday, while a gauge of global commodities reached the highest this year.
“There will continue to be a bid on Canada, with a budget like that,” Stefane Marion, the chief economist at National Bank of Canada, said by phone from Toronto yesterday. “The market was way too aggressive pricing in a rate cut in Canada just a few weeks ago.”
Marion forecasts the currency will end the year at C$1.10 as stronger global growth supports commodity prices and in turn sends money into federal and provincial coffers to support programs or tax cuts to bolster Canada’s economy.
“It’s too early to be bearish on the Canadian dollar in 2014,” he said.
The yield on the two-year benchmark government bond, the one most closely tied to short-term rate expectations, climbed this week above the Bank of Canada’s 1 percent policy rate for the first time since the Jan. 22 rate decision -- a signal investors see less chance of a rate cut.
Canada’s budget, delivered Feb. 11, projects almost C$45 billion ($41 billion) in surpluses over four years, giving the government a war chest for increased spending and tax cuts to help spur flagging economic growth. It forecasts a deficit of C$2.9 billion for the fiscal year starting April 1, the last of seven straight deficits before Canada swings to a C$6.4 billion surplus in 2015.
Analysts have reduced their median year-end forecast for the Canadian dollar 0.45 percent this month, the smallest median cut since September. In October, they trimmed their forecasts 3.9 percent after the Bank of Canada dropped language about the need for higher interest rates it had included in policy statements for over a year.
Last month, analysts reduced their forecasts by 1.4 percent and the currency fell 4.5 percent, the most in a January in records compiled by Bloomberg dating back 42 years. The Bank of Canada cited currency strength as a headwind to exporters and left the door open to a rate cut by saying inflation would fall below target this quarter.
“The Bank of Canada probably is somewhat comfortable where the Canadian dollar is and where rates are, and they’re unlikely to change their view on that,” David Watt, the chief economist at the Canadian unit of HSBC Holdings Plc, said in a Feb. 7 interview from Toronto. “We might not feel exactly that things are going gangbusters in Canada but the underlying trend, and hopefully with exports specifically, is we’ll see better volumes.”
Watt forecast Jan. 8 that the Canadian dollar will end the year at C$1.10 per U.S. dollar, and while he said he may lower his forecasts slightly, his view that the central bank won’t cut rates means the currency has less room to fall.
“We just don’t see as much downside now as we did six months ago, or five months ago,” he said.
The cost to insure against further declines in the loonie versus its U.S. counterpart is at the lowest in more than three years. The three-month 25-delta risk-reversal rate fell as low as 0.54 percent Feb. 10, the least since November 2010. It peaked at 4.43 percent in October 2011. Risk reversals measure the premium on options contracts to sell Canadian dollars versus buying U.S. contracts that do the opposite.
“The market got very bearish on the Canadian dollar early this year -- the rates market started to price in the risk of policy easing,” Daniel Katzive, a director and head of FX strategy, North America, at BNP Paribas SA, said Feb. 7 in an interview in New York. “What we expect is that the Bank of Canada is going to be on hold this year. Ultimately, the next move is a rate hike.”
BNP sees the loonie staying at C$1.10 per U.S. dollar in the first half of this year before strengthening by year’s end to C$1.08.
Swaps traders have reduced bets on an interest-rate cut. After the last Bank of Canada meeting, they were pricing in 16.7 basis points of easier monetary policy by the Oct. 22 gathering. Yesterday, they were pricing in only 2.6 basis points, Bloomberg calculations based on trading in overnight index swaps show.
Hedge funds and other large speculators have reduced bets the loonie will fall versus its U.S. peer for two straight weeks, data from the Washington-based Commodity Futures Trading Commission show. The difference in the number of wagers on a decline in the loonie compared with those on a gain, known as net shorts, totaled 60,300 contracts as of Feb. 4, down from 70,327 on Jan. 21. They reached a record 84,906 in January 2007, CFTC data show.
Those betting the Canadian dollar will resume its decline point to forecasts for weaker oil prices combined with a shrunken manufacturing sector as limiting the gains the country will see from exports.
Crude oil is forecast to fall to $94.50 per barrel by year’s end, from $100.31 yesterday, according to the median estimate in a Bloomberg survey, while Canadian manufacturing employment in the past decade has dropped 23 percent, and barely recovered since the recession.
“Even if we see the U.S. economy recovering, we are going to see one of the weakest spillovers into the Canadian economy of any U.S. recovery in recent history,” Steven Englander, the global head of foreign exchange at Citigroup Inc., said by phone from New York. “At these levels, given the choice of putting a car factory in Canada or putting a car factory in the United States or Mexico, I think Canada is choice No. 3.”
With weak oil prices, the only way Canada will rebuild its manufacturing base is if the loonie falls to C$1.20, which it will do over the next two years, Englander said.
Others point to better-than-forecast Canadian job creation and a decline in the unemployment rate coming amid rising commodity prices driven by steady global growth. Futures of crude oil, Canada’s biggest export, have risen 2 percent this year and the Standard & Poor’s GSCI Spot Index has risen 5 percent since reaching a low for the year on Jan. 9.
The loonie will weaken to C$1.12 per U.S. dollar by the end of March before strong commodity prices help it back to C$1.09 at year’s end, according to Hendrix Vachon, an economist at Desjardins Group, and the best currency forecaster in the fourth quarter after Macquarie Bank, according to Bloomberg rankings.
“The market priced more and more a decrease of the key interest rate in Canada,” Vachon said in a Feb. 11 interview from Montreal. “It really put a lot of pressure on the downside for the Canadian dollar actually, but we expect that to be only temporary. That’s why we are a bit more hawkish on the Canadian dollar by the end of the year.”
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