Canadian Dollar 2009 Forecast

It is almost hard to believe that a little more than 1 year ago, one Canadian dollar was worth more than one US dollar.   The USD/CAD exchange fell to a record low of 90 cents in November 2007, prompting the Canadian edition of Time Magazine to name the Loonie the Newsmaker of the Year.  However since then, it has fallen hard.  In 2008, the Canadian dollar dropped to a 2 year low against the US dollar, a 9 year low against the Euro and an 8 year low against the Japanese Yen.  However CAD weakness was not universal.  Currencies that also lost value against the Loonie include the British pound, New Zealand and Australian dollars.  Looking ahead, the odds are still skewed towards further losses for the Canadian dollar.  

Canada: Recession Only Beginning

The recession in Canada is only beginning.  According to Statistics Canada, the Canadian economy slipped into recession in the beginning of the fourth quarter.  Contrast that with the US, which has been in a recession since December 2007.  It is not a surprise to see Canada trail behind the US because up until this summer, soaring oil prices kept part of the economy well supported.  However, a lot has changed since the Summer of ’08 and now Canada is faced with the double blow of slowing US growth and significantly lower oil prices.  In the third quarter, Canadian GDP rose 1.3 percent, but more recent data for October indicates that growth contracted by 0.1 percent, on slowing shipments of cars and lumber to the US.  We are only beginning to see the weakness manifested in consumer spending and the labor market.  In the month of October, retail sales contracted by 0.9 percent, the largest drop in 8 months and for the same period employment fell by the largest amount in 26 years.  Still, the Canadian economy is not expected to contract as much some of its international counterparts.  Finance Minister Flaherty predicts that GDP will shrink by 0.4 percent next year, which is nominal compared to a 1 percent decline expected for the US and the 2.5 to 4 percent decline expected in Japan.   

Slowdown in the East and West

The Canadian economy is heavily dependent upon energy production and manufacturing.  In the past, the slowdown in one sector could be masked by a boom in the other.  This was case for most of 2007 and the first half of 2008.  Soaring oil prices helped the 3 energy rich western provinces of Canada (British Columbia, Alberta, and Saskatchewan) carry the economy.  However in the second half of 2008, oil prices came crashing down, falling more than 75 percent in a matter of months.  This dealt a strong blow to the Western Part of Canada at a time when the central and eastern parts of the country were already floundering.  The automobile industry has been hit hard by the credit crisis and unfortunately for Canada, the auto sector is their largest manufacturing industry.  Ontario, houses plants for major American and Japanese automakers and they have been dragged down by their US counterparts.  The automobile industry is in such bad shape that Prime Minister Harper announced a CAD3.3 billion rescue plan for the US automakers in Ontario.  Seventy percent of Canada’s trade is with the US so as long as the US economy continues to slow and oil prices remain below $45 a barrel, the Canadian dollar will have a tough time recovering.  

Core Inflation is Actually Accelerating

Interestingly enough, Canada is one of the few countries to report higher inflation.  In the month of November, core prices rose 0.7 percent, pushing the annualized pace of growth from 1.7 to 2.4 percent.  Headline prices, which includes the impact of oil eased, but not by nearly as much as the market had expected.  The annualized growth of headline CPI is still above 2 percent.  The weakness of the Canadian dollar contributed to a sharp rise in food prices, which increased 7.4 percent yoy that month, the fastest pace of growth in 22 years.   From the beginning of October to the end of November, the Canadian dollar fell more than 20 percent against the US dollar.  Currency impacts can have a lagged effect on prices which may be a reason why we are only seeing the impact now.  Stronger inflationary pressures will make it more difficult for the Bank of Canada to cut interest rates aggressively.  

Bank of Canada Will Continue to Cut Interest Rates, But Not to US Levels

Since the beginning of 2008, the Bank of Canada has cut interest rates by 275bp to 1.5 percent, the lowest level since 1958.  Even though they have been fairly aggressive, more interest rate cuts will be needed to deal with what could be one of the worst years ever for the Canadian economy. The Canadian government has already pledged more monetary and fiscal stimulus therefore it should just be a matter of time before the BoC takes interest rates below 1 percent.  Although the idea of zero interest rates have been floated around, the weakness of the currency should continue to keep inflation around the central bank’s 2 percent target and for that reason we do not expect them to take rates down to US levels.  The Canadian economy is only beginning to slow and the prospect of more interest rate cuts will make the Canadian dollar vulnerable in the beginning of 2009.  

Things to Watch Out For:  Foreign Investment, Current Account Deficit and Political Risk

If falling oil prices and slower US growth aren’t enough of a burden on the Canadian economy, falling bond yields have made Canadian investments increasingly unattractive.  Over the past few years, soaring oil prices added to the allure of Canadian dollar investments, but now that 2 year bond yields are less than 50bp and oil prices are no longer supporting the economy, we could see foreign investment dwindle.  This in combination with lower weaker exports should lead to Canada’s first current account deficit in 10 years.  Prime Minister Harper has received a lot of criticism in 2008 and there is a strong chance that more political infighting could force his minority government could to fall.  Harper has already suspended Parliament until the end of January in order to avoid a no-confidence vote.  In the currency market, political risk can add downward pressure to the currency.   Although most arguments favor more weakness in the Canadian dollar next year, it would only take a recovery in the US economy or a sudden rally in oil prices to turn things around.  

Technical Outlook for USD/CAD  

After breaking parity for the first time ever late last year, USD/CAD experienced a rally throughout 2008.  Despite numerous tests, the pair failed to break the 1.3000 level and instead formed what could be a triple top.  This triggered a reversal in the currency pair that took it back below 1.20. USD/CAD is still trading well above the 50-week and 200-week SMA which means that the uptrend may still be intact. The price retraced 23.6% from a low established in 2007 and a high of 2008 and may be forming a cup-and-handle pattern. A break back above the first standard deviation Bollinger Band at 1.25 will be needed to officially reinstate the uptrend in the currency pair.  If it fails to break that level and instead falls below 1.20, then we could see a move to 1.15, which is the Fibonacci support of the same move that was mentioned earlier.