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Commentary

Loonie: The Little Currency has Spunk…
 
By Douglas Porter, CFA, Chief Economist, BMO Financial Group
February 2017
 
...and the Bank of Canada hates spunk. In fact, it’s really not a “little currency” at all, given that the BIS says it was the sixth most actively traded in the world last year and it is the fifth largest holding in foreign reserves. But there is little debate that the Canadian dollar is proving to be surprisingly resilient, and most likely to the ongoing chagrin of the central bank.
 
Since the U.S. election, the Canadian dollar has actually managed to strengthen by just over 1%, as it held broadly steady this week at just over 76 cents ($1.31/US$). That makes it one of the strongest currencies in the world over that stretch, trailing behind only Brazil and Taiwan. Given that the Bank of Canada often cites “competitiveness challenges” when speaking about Canada’s stubbornly disappointing export performance, it’s pretty clear that this is a less-than-welcome development for policymakers. And, in turn, the loonie’s spunk is often cited as the primary factor behind the Bank’s relentlessly dovish message.
 
There are at least three reasons why the currency has held up so well in recent months. First, firmer oil prices. While some have downplayed the link between the currency and crude, and the direct daily correlation has notably weakened recently, oil and other commodities are still a major driver over time for the loonie. WTI stood at just under $45 on election day and has subsequently had a near-20% bump to over $53, largely thanks to the OPEC production deal.
 
Second, the US$ itself has lost steam in recent weeks. In fact, since the start of 2017, the greenback is actually down against every major currency in the world, reversing much of the post-election bump. Yes, it’s even down a tad against the Mexican peso since the start of the year.
 
Third, Canada’s economy has been surprisingly and refreshingly perky in recent weeks. To wit, job growth has just had its best six months in 15 years (up 239,000), housing remains strong, auto sales are coming off a record year, the trade balance has turned from red to black, and even manufacturing sales ended last year on an upbeat note. We are still looking at GDP growth of around 2% for Q4 and for all of this year, but now see some real upside risk to that call. True, it will take more than that to impress the BoC, given that they are at the high end of consensus at 2.1% for this year. But it’s been quite some time since anyone has talked about upside risk for Canadian economic growth.
 
The resilience in the C$ is being reflected in capital flows, which are suddenly very positive for the currency. StatsCan reported today that foreign investment in Canadian securities hit a record high in 2016 at a massive $161 billion, with large inflows into both bonds ($105 billion) and stocks ($53 billion). To put that big figure into context, it’s 2.5 times as large as the estimated current account deficit for the country last year ($64 billion), and it’s well above the prior annual record high set in 2010 (a year the C$ soared above parity). Perhaps more remarkably, Canadian purchases of global securities almost dried up last year to a meagre $14 billion, leaving Canada with a huge portfolio capital account surplus, and helping explain how the currency rebounded so very forcefully in the past year.
 
Where do we go from here? Capital flows can turn on dime, but we do know that Canada’s trade and current account are poised to improve further over the next year, provided oil prices hold up. Another plus for the C$, is that U.S. officials are likely going to continue talking down the big dollar. Still, we remain defensive on the loonie’s outlook, for two primary reasons—interest rate differentials, and potential U.S. trade measures. There is still the very real risk that the Fed could tighten more than the two rate hikes currently built in by markets this year, especially after the recent wave of upbeat U.S. growth and inflation data. On the flip side, we believe that market pricing of roughly a one-third chance of a BoC rate hike this year overstates the odds by… oh… about one-third.
 
On the trade front, we and almost everyone else were breathing a little easier after the uneventful and upbeat meeting between Prime Minister Trudeau and President Trump this week. Trump’s proposed “tweaking” of NAFTA has some concerned, but that’s a long way from “tearing it up”, and most reasonable folks would agree that a tweak is in order for a pre-internet trade pact. As well, the market seems to be of the view that the Border Adjustment Tax—which would bring an earthquake to FX markets—is unlikely to see the light of day (one Senator said it’s “on life support”). Even so, the risks of some such move are not zero, and are serious enough to warrant caution on all currencies. On balance, we have nudged up our forecast for the year to a 74-cent average and even that may prove to be too low, but not if the U.S. turns truly protectionist.
 
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A market bubble is in the eye of the beholder, and even when a bubble is identified it can grow much larger and possibly for many years. Alan Greenspan spoke about irrational exuberance in U.S. stocks in late 1996, and the tech bubble only burst in early 2000 after a near-quadrupling of the Nasdaq after his warning. Our only goal of calling Toronto’s housing market a bubble was to reinforce the message that it had become divorced from economic fundamentals and was becoming potentially dangerously overheated. This is not a near-term call on the market—in fact, given the outlook for interest rates and an improving underlying economy, there’s nothing obvious to meaningfully slow the market at this point.
 
And to those who question whether it is a bubble, we can only hazard to guess that they haven’t been looking to buy or sell a home in the past year and are blissfully unaware of the reality on the ground. A random sample of homes that sold this month alone shows a median selling price of 25% over asking, with not one staying on the market longer than eight days. Even pigs are flying in this hurricane of a market.
 
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Douglas J. Porter, CFA | Chief Economist
BMO Financial Group