Canadian Dollar Forecast: Another Interest Rate and Weakness Lie Ahead

Analysts at BNP Paribas say the Bank of Canada will be forced into another interest rate cut - a negative move for the value of the CAD

Underlying U.S. dollar strength and weaker oil prices below $45 kept Canada’s commodity influenced currency near the three-week lows hit Friday.

Near-term, the loonie will take a fundamental cue in Friday monthly growth data, forecast to show the economy grew a third straight month in August, albeit barely with forecasts of 0.1 percent.

The soft growth data has not been enough to convince the Bank of Canada that rates should remain where they are.

Indeed the steady rates profile - arguably a positive for the CAD at this stage - come despite the BoC revising down growth projections for 2016 and 2017 while expecting economic slack to persist until mid-2017.

The BoC appears to be relying on a spending boost from the incoming Liberal government to boost the economy next year.

But, "the BoC’s inaction may still prove too optimistic, especially if the fiscal boost is slow to materialise," says Vassili Serebriakov with BNP Paribas.

Interestingly Serebriakov reads the BoC as being more optimistic than the Fed on US growth.

"Most policy scenarios imply US-Canada rate differentials rising into the year end, pushing USDCAD to 1.38," says Serebriakov.

Analysts believe the downward revisions to the growth forecasts in the Monetary Policy Report speak louder than the BoC’s optimistic rhetoric.

Furthermore, the fiscal boost will take time to materialise, suggesting that the risk of further BoC easing is higher than markets are willing to price in.

The Liberals scored a surprise decisive victory in the Federal elections on Monday (19 October), gaining an outright majority.

This implies that the Liberals’ fiscal plans, namely three straight years of a “moderate” (under CAD 10bn) budget deficit to finance additional infrastructure spending, are likely to go ahead.

At face value, BNP's economists argue that the additional spending could add as much as 0.5pp to 2016 GDP growth, probably taking some pressure off monetary policy to support the economy.

"It is also noteworthy that the BoC’s projections for the US economy are more optimistic than the Fed’s to the tune of 0.3pp of extra GDP growth in 2016 and 2017 versus the median forecast in the Fed’s summary of economic projections," says Serebriakov.

This is cited as an example of the policy divergence being created either side of the border: either the BoC’s more optimistic projections for the US prove right and the Fed has to tighten or they prove wrong and the BoC has to cut.

The wedge will drive the dollar higher against the CAD, "either scenario leads to a higher USDCAD," says Serebriakov.

The market went into Wednesday’s BoC meeting (21 October) with a firmly neutral bias on rates that did not price in any BoC rate cuts over the next 12 months.

"We think the risk of a cut over the next six months is higher than is currently priced in, with near-term risks from the housing markets persisting and fiscal spending unlikely to provide meaningful growth support until well into 2016. This suggests a flat to lower profile for Canadian rates," says Serebriakov.

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