USD/CAD is set to rise above 1.40 over the course of 2017, predominantly driven by faster-than-priced Fed tightening and US tax reform. A possible US border tax adjustment would boost the broad USD and have a disproportionately negative impact on Canada’s growth by reducing investments and exports, unless offset by depreciation. Domestically, expectations of Bank of Canada tightening are unlikely to pick up before H2 as the positive output gap and macro-prudential measures in the housing market continue to keep inflation well below target. Finally, even with higher oil prices, the Canadian dollar should continue to be pressured lower by a persistently deteriorating external position.
Starting in Canada, we expect the BOC to hike rates only once toward the end of 2017 as the output gap closes. There is considerable uncertainty as to the timing of a first BOC rate hike, largely because of disparate views on the level of potential growth. The Bank of Canada estimates it at 1.75%, but we estimate the range to be as wide as 1.4 – 2.9%, using the Bank’s own models. Inflation tends to pick up only when growth moves close to the upper-bound estimate of potential growth. This is very unlikely to happen in the first half of the year given macro-prudential measures taken to cool down the over-heated housing market. These measures, in our view, are largely responsible for the BoC’s forecast of a 30bps decline in core inflation in 2017 given that shelter and household operations account for 40% of the CPI basket.
In contrast, we expect the Fed to tighten at a faster pace than is priced by the market, and especially so as we head into 2018, by which time fiscal stimulus is likely to have kicked in fully. Based on regressions, USD/CAD would rise to between 1.37 and 1.43 based on consensus interest rate two year forecasts, assuming that the other key driver, oil, remains constant. Regressions also suggest that a surprise Fed hike in Q1 could propel USD/CAD by up to five cents, from levels that already look slightly cheap against the current two-year nominal rate spread. To be sure, the impact of a faster-than-priced Fed hiking cycle would likely be lower than a regression suggests because it would likely be prompted by a faster-growing US economy, with positive ramifications for Canadian exports. Nonetheless, the simple beta underscores the extent of the upside potential should the Fed surprise on the hawkish side this year.
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So far President-elect Trump has gone out of his way not to pick on Canada. Were this to change, the CAD would be especially vulnerable to trade tensions. The US accounts for 70% of Canada’s exports, which in turn account for 30% of its GDP. The automotive sector—of which the President-elect appears to feel particularly protective at home–accounts for a quarter of exports, even as Canada has struggled under cheaper Mexican competition. The sector also employs 7% of the manufacturing sector with only a fraction employed by three large US manufacturers. Any US pressure to re-shore or repeal NAFTA would seriously damage investments in Canada, hurt exports and reduce potential growth.
Even a symmetric US border adjustment of 20%–far from the most protectionist outcome–would hurt Canadian exports materially unless or until the exchange rate adjusts. Given Canada’s 50% import dependency on the US, the highest in the world, it would experience the greatest terms-of-trade effect from a US move to a VAT system. On the export side, a key industry, the oil sands, is especially vulnerable to a structural boost to US competitiveness given the oilsands’ higher overall operating cost compared to US shale oil.
Moreover, assuming that the tax changes are not yet fully priced in, the CAD is especially vulnerable to an unwind of the very large unhedged equity position held by foreigners as US stocks become notably more attractive, not least thanks to buybacks or dividend hikes facilitated by a likely repatriation holiday. Equities dominate Canada’s external local currency position, and sudden withdrawals would put a significant dent in the balance of payments.
Lastly, even in a scenario where none of the above risks from US policy materialized, we would nevertheless expect the current account deficit to persist and average around $50bn in 2017. Over the course of the year, it could improve courtesy of a steady recovery in exports and improve from $60bn in Q1 to below $50bn in Q4. But of course this still adds to Canada’s net external debt position at a rapid clip, at the same time as rising rate spreads raise the cost of funding the large deficits by reducing bond inflows in the absence of significant depreciation. Overall, an already deep and still deepening basic balance deficit will continue to exert downward pressure on CAD.
