Brett Girard discusses the Canadian dollar
Already one of the best-performing major currencies this year, Canada’s dollar looks poised to become a market favorite for all of 2021.
At the heart of the loonie’s broad gains are demand for the country’s abundant natural resources, attractive yields and proximity to the U.S., where vaccination rollouts and infrastructure spending are seen helping Canada’s biggest export market regain its footing.
Against that reflation-trade backdrop and relative calm in equity markets, the Bank of Canada signaled it will slow quantitative easing. That’s fueled the currency’s largest quarterly return in years against two haven counterparts: the yen and Swiss franc. Even versus the dollar, which defied dour forecasts to post its best quarter in a year, the loonie rose more than 1 per cent, and it’s just behind the British pound for the title of best major currency so far this year.
“The Canadian recovery will be impressive in the second half, with growth projections revised up,” said John Velis, a strategist at BNY Mellon, who is long the loonie versus the dollar. “Furthermore, the global reopening will help commodities as we get deeper into the year and we’ll see commodity- and oil-related FX do well.”
The loonie’s first-quarter performance is unlikely to be just a flash in the pan. With economies of Group-of-20 nations forecast to rebound this year, U.S. and Canada rank in the top five, seen expanding 5.7 per cent and 5.4 per cent, respectively, according to Bloomberg data. As growth gains traction and major central banks remain accommodative for the foreseeable future, rising demand for commodities could support the currency well into next year.
While commodity prices and the loonie don’t move in lockstep, the 21-day correlation between the Bloomberg Commodity Index and Deutsche Bank AG’s trade-weighted index for the Canadian dollar is above 70 per cent and near the highs seen in the past five years. U.S. President Joe Biden’s “green” infrastructure packages should further underpin prices with some analysts touting an impending commodity supercycle.
Philippe Jauer, a money manager at Amundi Asset Management, says the Biden spending package will be bullish for the Canadian dollar and other resource-linked currencies. The administration is moving “swiftly, massively and this is what the market is looking at for now,” he said, adding that Canada’s export market stands to benefit.
Jauer is following a butterfly strategy that comprises long bets on the dollar, commodity-linked currencies and a short on the euro. He favors the Canadian dollar versus most other G-10 currencies except the greenback.
The combination of solid growth and subdued inflation is particularly appealing to fixed-income managers. Headline consumer-price inflation in Canada is running about 1.1 per cent per year -- below a 1.7 per cent reading in the U.S. The five-year breakeven inflation rate for Canada, a gauge of bond market expectations for consumer-price gains, is around 1.9 per cent, compared with around 2.6 per cent for a similar U.S. measure.
With Canadian government yields in maturities of five years and less exceeding that of U.S. counterparts, carry returns are comparatively attractive. Among higher yielding nations, Canada’s favorable sovereign ratings and limited U.S. dollar funding concerns make it an attractive alternative to many emerging-market counterparts.
Not everyone is upbeat on the loonie. For Bipan Rai, a strategist at Canadian Imperial Bank of Commerce, the global growth story is already priced in and he anticipates weakening versus the greenback as markets re-price central bank policy. “Put simply, we don’t think that the Bank of Canada will hike ahead of the Fed when push comes to shove post-2021.”
There are also risks to the growth outlook, among them the potential failure of vaccines to rein in the pandemic and challenges that Biden will face to get his spending plans approved. But at the moment, markets are betting on a brighter outlook.
One-year implied volatility in the Canadian dollar last week plummeted to the lowest level in more than a month -- a sign that options traders are getting more comfortable with loonie stability longer term. Technically, the loonie is flirting with key long-term hurdles against the U.S. dollar, euro and yen. Versus the greenback, a double-top and descending wedge pattern since March 2020 have spot slowly approaching a 2015 support line at around $1.2280, from its current level of about $1.2536.
That’s a level to be tested this year, if Greg Anderson at Bank of Montreal is right. He’s got a year-end outlook of $1.22, which would be the strongest since 2017, and sees yield differentials helping guide the way. Canadian two-year rates still exceed equivalent U.S. debt by about 6 basis points and their German counterparts by about 95 basis points. Canadian yields have largely kept pace with jumps in Treasury rates, so that pulled the loonie higher on lots of crosses, said Anderson.
“The yield differential that has opened up will still create a bit of attraction for the loonie on crosses,” he said. “And that should help it outperform.”