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Canadian Dollar Outlook

Last updated 1/4/2012 5:03 AM ET (GMT -5) 0 Comments - Add your comment

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Kathy Lien

Director of Currency Research, GFT

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The Canadian dollar lost value against all of the major currency pairs in 2011. Some people may find this surprising because Canada does not have the weakest economy in the world nor does it have the weakest balance sheet. In fact, of all the G20 countries, Canada is among the strongest and its balance sheet is in an enviable position. Yet, if this is true, then why did the Canadian dollar weakened this past year? The answer is simple – Canada is an export-dependent economy and its currency has had an extremely high correlation to beta, which means that it is particularly sensitive to risk appetite. When equities started to fall in August, the Canadian dollar reversed all of its year-to-date gains and has had a tough time recovering since then. Brighter times lie ahead for the Canadian economy and in 2012, its fiscal position will be a shining star. That may not necessarily translate into strength for its currency unless the uncertainty in Europe is eliminated; at the end of the day, the Canadian dollar is still a risk currency.

Domestic Economy Doing Well, but Exports are the Problem

If we looked at the Canadian economy exclusively, we can easily argue that the country is on the road to recovery. The economy expanded by 3.5% in the third quarter thanks to strong sales of aircrafts and exports of industrial goods such as metals. Improvements have also been seen in the labor market and retail sales have rebounded as well. The manufacturing sector continues to expand after contracting briefly in July. Oil prices have also been on the rise and along with strong demand from emerging economies, commodity exports out of Canada should remain well supported. The government is also in the process of negotiating a trade agreement with the European Union and a perimeter-security deal with the U.S. that will reduce delays of goods being transported across the border. If these discussions go smoothly, it could increase trade and promote growth for Canada. Nonetheless, exports are also a very important part of the Canadian economy; with three quarters of Canadian exports destined for the U.S., the possibility of slower growth in the first half of the year poses a big risk for Canada. Demand from Asia can help, but for the time being, only 3.3% of the country’s exports are headed for China. External risks are the main reason why the Bank of Canada expects growth to slow slightly in 2012. Their latest forecasts call for 2.1% growth in 2011 and 1.9% growth in 2012.

Will the Bank of Canada Cut Interest Rates?

The central bank kept interest rates steady at 1.00% throughout the past year and, like many other central banks around the world, they believe that Europe’s troubles pose major risks to their local economy through financial confidence and trade channels. As such, they expect momentum in the economy to remain modest throughout the middle of next year, which explains why they removed a reference to withdraw stimulus from their monetary policy statement in October. With this change, they have shifted themselves from a tightening to a neutral bias. For the time being, we believe that the Bank of Canada will keep rates on hold next year; but if economic conditions worsen, the BoC certainly has room to ease and they wouldn’t be shy about doing so having taken interest rates down to 25bp in 2009. Unlike other central banks whose economies may be in worse shape, the BoC has no need to be overly proactive – they can wait and see how the global economy fares before taking action.

Good Politics Equals Good Fiscal Policy

Two of the main advantages that Canada has in the coming year are strong fiscal position and political stability. Unlike the U.S. where President Obama will be fighting for reelection, Prime Minister Harper will remain comfortably in office after having won a conservative majority in the House of Commons in May. Their budget deficit is only expected to be 0.9% of GDP in 2012 compared to a projected deficit of 7% of GDP in the U.S. Canada came out of the global financial crisis relatively unscathed allowing Prime Minister Harper to end emergency stimulus in 2011 and start to implement budget deficit reduction measures. As a result, no tax increases are needed in 2012 and any cutbacks in government spending will be nominal. With a well laid-out plan, Canada should come out a winner on a fiscal basis; being able to avoid the severe fiscal tightening that other parts of the world are experiencing could help the Canadian economy as well.

But…..the Canadian Dollar is Still a Risk Currency

However, when it comes to the currency outlook, even if Canada outperforms its neighbors, the Canadian dollar is still a risk currency; the performance of the global economy and the market’s appetite for risk can play a larger role in how the loonie trades than the performance of the local economy. If Europe falls into a recession in the first half of the year or a country like France is downgraded, triggering a wave of deleveraging, the Canadian dollar could easily get caught in the overall selling of risk. Unfortunately for the currency, the odds are skewed towards liquidation of risk rather than recovery.

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About The Author

Kathy Lien began her FX trading career 10 years ago at J.P. Morgan Chase. After graduating New York University’s Leonard Stern School of Business at the age of 18, Kathy joined the bank's interbank FX trading desk and eventually moved to the cross markets proprietary trading desk. In the interbank market, her ability to create solid fundamental and technical analysis from the myriad of information on the market helped her trade forex spot and options. Her experience eventually led her to be chief strategist at Daily FX where she worked until she joined GFT in 2008.

With her knowledge of forex, as well as her experience trading other products, such as interest rate derivates, bonds, equities, and futures, Lien has built a reputation as an international currency analyst. She is frequently quoted on CNBC, Bloomberg, Fox Business and Reuters. Lien has also written for publications like Active Trader, Futures, and SFO magazine. She is the author of the newly updated Day Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, and the co-author of Millionaire Traders: How Everyday People Are Beating Wall Street at Its Own Game with Boris Schlossberg.

To buy Kathy’s newly updated Day Trading and Swing Trading the Currency Market: Technical and Fundamental Strategies to Profit from Market Moves, click here.