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Weekly Talking Points

October 18, 2019
The Talented Mr. Loonie
Douglas Porter, CFA, Chief Economist,, +1 (416) 359-4887
In a week filled with tentative deals, markets rolled higher amid a rising appetite for risk. A big winner from that trend was the Canadian dollar, which pushed above 76 cents (US), close to its high for the year and up almost 2% in the past two weeks. The currency is hardly alone in the upswing, as the biggest driver of the recent move has been a broader sag in the U.S. dollar. Still, the loonie now stands as the strongest major currency in the world in 2019, rising 3.8% YTD, with its NAFTA partner next in line; the Mexican peso is up 2.7% this year.

It’s not hard to find reasons why markets were in a mildly upbeat mood this week, as a wide variety of thorns were close to being removed. In the past seven days alone, we have seen a preliminary agreement on “Phase 1” of a deal on U.S./China trade; a tentative deal on the GM strike in the U.S.; an agreement between the EU and the U.K. on Brexit; and, even a five-day standstill by Turkey in Northern Syria. However, investors contained their enthusiasm: in each and every case, the outcome still very much hangs in the balance. By Friday, global equities were aiming for less than a 1% gain, long-term yields were only slightly higher, and the greenback had nudged lower—the pound was the single-biggest mover, currently up more than 5% since the middle of last week.

Amid this wave of potentially key global developments, the Canadian dollar’s ascent is notable as it comes at a time of rising uncertainty ahead of Monday’s federal election. Polls overwhelmingly point to a close-fought minority government, with the two leading parties running neck-and-neck and also a close race for third place on the seat count. Some forecasts even suggest that it may require three parties to get over the 170-seat majority threshold. And, given how close the pollsters expect the results to be, it’s quite possible that it will take an extended period of time to sort out a) who actually won; and, b) how and with whom they are going to govern.

Many market commentators are downplaying concerns about the outcome, suggesting that minorities are far from rare in Canada, and that there isn’t that much daylight between the economic policies of the major parties. However, while Canada does have plenty of experience with minority governments (including three different versions from 2004 through 2011), a three-party dynamic is new. As well, while there isn’t a huge gap in the overall proposed thrust of fiscal policy, details differ widely, especially when considering some of the proposals of other parties—with potentially big implications for the energy sector at the very least. Suffice it to say, the preternatural calm of the Canadian dollar during the campaign is a surprise.

Of course, one key factor holding the currency aloft has been a sturdy underlying economic backdrop. The flashy employment results in recent months have grabbed the biggest headlines, with unemployment falling to just 5.5%, average hourly wages bouncing up by more than 4%, and jobs up by a cycle-high of 2.5% y/y. As well, the housing market has made a spirited comeback from last year’s tough results, with sales rebounding 15.5% y/y last month and average prices rising 5.3% y/y. The housing revival has been spread across most of the country, with double-digit sales gains and price increases in seven provinces. True, neither the jobs bonanza nor the housing rebound has translated into much in the way of overall GDP growth—we’re just expecting a 1.5% advance this year. But the outlook hasn’t deteriorated amid the turbulent global backdrop of recent months, which counts as a big win.

In turn, the firm backdrop for jobs and housing has put the Bank of Canada back on ice. We have long believed that the hurdle for any rate cut by the Bank would be very high. Initially, it appeared that a series of Fed rate cuts and intense global uncertainty would be enough to convince the Bank to trim rates. However, with Canadian core inflation grinding up to a cycle high (of 2.1% y/y last month), household borrowing beginning to stir again, and the loonie reasonably well-behaved, the case for a BoC rate cut has vanished, at least for now. Even looking all the way through 2020, markets are now priced for less than half a rate cut. That compares with roughly 60 bps of additional Fed trims, including still-high odds of a move on October 30.

As we have long pointed out, a Fed cut in two weeks’ time, along with an on-hold BoC that same day, will leave Canada with the highest overnight rate in the advanced world. Accordingly, Canadian two-year yields at 1.63% are also the highest among 22 countries surveyed. In the past six months, Canadian short-term yields have barely budged, even as others were plunging all around them. This factor alone helps explain the primary talent of Mr. Loonie—to keep its calm amid a turbulent global backdrop as well as a complete toss-up on the election.

Appearing on a panel of Chief Economists earlier this week, I was assigned a variety of puff-ball questions, ranging from: 1) thoughts on negative interest rates (“an abomination”, see this week's Focus Feature); 2) implications of an inverted yield curve (“it’s different this time, and it’s no longer inverted”); and 3) thoughts on the U.S. budget deficit (“how I learned to stop worrying and love the debt bomb”). But the final one was a bit trickier, and it’s an issue many have been grappling with for much of this year—how can you explain the solid gains in equities amid massive geopolitical uncertainty, trade wars, and a slowing global economy? To wit, the all-world MSCI is up almost 16% this year, battling for the second best year of the decade (it’s going to be tough to top 2013’s 22% rise).

The answer is two-fold: 1) we have to remember where we started the year—coming off a horrendous Q4, markets are now basically just back to where they were in September 2018. And, 2) the sudden pivot by central banks—most notably the Fed, of course—has helped slash bond yields and largely countered concerns on the trade front. But that raises a new question: What do we do for an encore with the Fed likely to stop easing after this next expected move? That question becomes much more pressing if some of the tentative deals fall through in the days ahead. On that note, here's hoping that it's not impolite to point out that Saturday's key Brexit vote is falling on October 19—a day of infamy for financial markets (think 1987).
Douglas J. Porter, CFA | Chief Economist | Managing Director, Economic Research