Loonie weakness to persist

Transcription

1 September 215 Loonie weakness to persist A looser yuan peg and subsequent devaluation of other currencies in the emerging world took the trade-weighted USD to levels not seen in a dozen years. The dollar rally, though already extended, still has legs due to diverging monetary policies between the Fed and other major central banks. Above-potential GDP growth slated for this year and continued strength in employment have got us ever closer to a first interest rate hike by the Fed in almost a decade. Interestingly, the USD s gains in August were not at the expense of the euro and the yen, both currencies benefitting from unwinding of carry trades amidst the global stock market rout. It s unclear, however, if those low yielding currencies can maintain the pace if financial markets stabilize. Both the Eurozone and Japan are seeing tepid growth and below-target inflation. So, expect the BoJ and ECB to continue running their printing presses at full speed over the next several quarters, something that should weigh on the euro and yen. The Canadian dollar remains under pressure. The outlook for oil prices is dull due to excess supply and weak global growth. Monetary policy is also not favourable with a widening US-Canada yield differential likely to hurt the currency. The large current account deficit and dependence on short term capital flows to finance it, are also not encouraging. Complicating matters is the upcoming federal elections which promise to add a dose of uncertainty. We expect USDCAD to trade in the range through the end of next year. Stéfane Marion/Krishen Rangasamy NBF Currency Outlook* Current 215Q 216Q1 216Q2 216Q3 216Q -Sep-15 USDCAD US cents per CAD EURUSD USDJPY AUDUSD GBPUSD USDCNY AUDCAD * forecasts for end of period Source: NBF Economics and Strategy

2 USD takes its cue from the Fed Thanks in part to Beijing s decision to loosen the yuan s peg which was followed by devaluations of other emerging market currencies the US dollar registered in August its eleventh monthly gain in the last 1 months, enough to take the world s reserve currency to its highest level since 23. The year-onyear appreciation of the trade-weighted USD is now similar in magnitude to the surge seen during the global financial crisis of 28/9. USD reaches 12-year high Trade-weighted US dollar Index Level (L) y/y chg. (R) In August 215, trade-weighted USD was at highest point since % 2 But this time, it s not safe haven flows that are propping up the greenback but rather diverging monetary policies. While the Bank of Japan and European Central Bank are now well involved with quantitative easing, and the People s Bank of China is cutting interest rates and reserve requirements, the Fed is moving in the opposite direction. The FOMC has indeed repeatedly expressed its concerns about financial stability which it thinks may be compromised by persistently low interest rates. As the Fed said recently, if it is reasonably confident that inflation will move back up to its 2% objective over the medium term and if it has seen further improvement in the labour market (which it has thanks to July s and August s employment numbers), it will be raising the fed funds rate. However, the Fed knows it can t get too aggressive when it starts a new tightening cycle. The inflation rate remains well below target and too much tightening too soon has potential to send the US economy into deflation mode. Excluding the owners equivalent rent the latter is being inflated by high demand for rentals (which won t be curtailed by rate hikes) core CPI inflation is running at just 1.3%. Similarly, the core PCE deflator is now running at 1.2%, the lowest in over four years. Wage inflation is also proving to be persistently soft despite the solid labour market Fed can t get too aggressive with rate hikes due to low inflation US Core CPI y/y % chg Owners equivalent rent Core 1.2 Core excluding OER.8.. Jul Why is US inflation so low? Part of the reason inflation is so low is the still-large amount of slack in the economy. Even after the GDP surge last quarter revised figures show output expanded 3.7% annualized in Q2 output remains about 3% below potential. U.S.: Economic slack still large, even after GDP surge in Q Trillions of 29 dollars 1 % Q NBF Economics and Strategy (data via Congressional Budget Office, Datastream) The strong dollar is also to blame for low inflation. The appreciating greenback has chopped a few ticks from economic growth and also caused import prices to fall, both working to pull the inflation rate down Real GDP: Actual and potential Potential GDP Q Output gap U.S.: Strengthening dollar causing import prices to fall Non-petroleum import prices and Trade-weighted USD y/y % chg. y/y % chg. 8 reverse axis -2 Non-petroleum import prices (L) Trade-weighted USD, 3-month lag (R)

3 All told, while the Fed has repeatedly warned about a hike of the fed funds rate soon, we expect it to be ultra-cautious when tightening, i.e. a couple of hikes (if any) followed a long pause. That, nonetheless, should be enough to propel the trade-weighted USD a bit closer to its all-time high reached back in 22. Carry trades unwound Interestingly, the USD s gains in August were not at the expense of the euro and the yen. The latter two currencies, under pressure earlier in the year thanks to low interest rates in both regions which has encouraged carry trades i.e. investors borrowing in low yielding currencies such as yen or euro and buying higher yielding currencies such as the A$, made a comeback in August thanks to unwinding of carry trades amidst the global stock market rout. It s unclear, however, if those low yielding currencies can maintain the pace if financial markets stabilize. Both the Eurozone and Japan are seeing tepid growth and below-target inflation. At its September meeting the European Central Bank acknowledged that GDP has grown at a slower pace than earlier expected and accordingly lowered its growth and inflation projections. That prompted the central bank to tweak its QE program a bit by allowing for more purchases of debt from each member countries by raising the potential purchase limit to 33% of any bond. The Bank of Japan is in a similar bind and there is therefore more stimulus ahead. All told, expect the BoJ and ECB to continue running their printing presses at full speed over the next several quarters, something that should cause both the euro and yen to depreciate against the USD. Inflation well below target even excluding food and energy Core CPI 2.8 y/y % chg BoJ and ECB target Jul Eurozone Japan Loonie s weak fundamentals It s been a rough summer for the Canadian dollar. The currency lost over 6% against the USD in the last two months hammered by slumping oil prices amidst concerns about global growth. The weak domestic economic outlook also raised the probability of another rate cut from the Bank of Canada, further weighing on the currency. Indeed, Canada was in a so-called technical recession in the first half of 215 with GDP contracting for a second consecutive quarter. The.5% annualized drop in Q2 was driven by sinking investment which more than offset contributions from consumption, government, residential construction and trade. But not all is bleak. While the energy sector is clearly in recession, the rest of the economy is doing better. The non-energy sector seems to have recovered somewhat after a poor start to the year. Canada: Energy collapse reminiscent of 28/9 recession Real GDP by industry 12 q/q % chg. saar NBF Economics and Strategy (data via Statistics Canada) Nonenergy Energy But Canada isn t out of the woods. While the economy likely got a nice bump in Q3 from the PanAm games and the checks sent out by Ottawa to households (family tax credit), old problems resurfaced. Indeed, after showing some signs of recovery, energy prices relapsed in the third quarter. Adding insult to injury, the spread i.e. the difference between West Texas Intermediate and Western Canada Select (the price received by our oil exporters) widened sharply in response to the glut of heavy oil due to some pipeline shutdowns and reduced capacity at refineries either due to seasonal shutdowns or for less temporary reasons, e.g. the refinery in Whiting (Indiana) that processes heavy Canadian oil is undergoing repairs after being damaged. All told, the WCS price drop in Q3 was significant and likely hurt the gross domestic income. Q2 3

4 Canada: Energy price relapse 1,9 1,8 1,7 1,6 1,5 1, 1,3 1,2 1,1 1, 9 8 Index Bank of Canada energy price index and WCS-WTI spread BoC energy price index (L) Relapse in energy prices and spread US$/barrel Spread (R) Q3 215est NBF Economics and Strategy (data via Bank of Canada, Bloomberg) Quarterly price changes for WTI and WCS oil WTI spread C$ WCS in C$ 21Q3 21Q 215Q1 215Q2 215Q3 With declining revenues and a rather dull outlook for oil prices, energy producers will remain in cost-cutting mode. A casualty of that will be investment spending which is poised to decline further after taking a beating in the first half of the year. Even outside the energy sector, the outlook for business investment isn t rosy. Low interest rates have yet to entice firms to increase investment outlays as profits remain challenged. If we re correct about the extent of the investment slump, that would equate not only to weak growth this year, but also to lower potential growth for 216 and beyond. That sets the stage for a significant divergence in monetary policy between Canada and the US. A wider yield differential is likely to hurt the C$. Adding to the loonie s challenges are unfavourable capital flows. While the latest report on the balance of international payments showed an improvement in Q2 for the current account balance, the broadest measure of trade, thanks to smaller deficits for goods trade, services trade, and the investment income account, the deficit nonetheless remained sizable at 3.5% of GDP. % were much bigger than C$ depreciation, meaning that producers will likely experience slump in Q3 revenue est. But the really bad news was the way the C$17. bn deficit was financed. The preferred source of financing, i.e. FDI (because it is stable and long term), was negative for a third consecutive quarter, i.e. net direct investment by foreigners were more than offset by massive outflows by Canadian corporations whose direct investment abroad hit nearly C$37 bn, the highest on records. Ditto for portfolio flows, whose foreign inflows into Canadian securities were dwarfed by outflows relating to investment by Canadians into foreign securities. Instead, the external deficit in the second quarter was financed entirely by other flows, such as loans, currency and deposits. Those relatively unstable flows because they have potential to quickly reverse largely explain the Canadian dollar s slump in recent months. Canada: Weak fundamentals for C$ Current account balance Current account C$ bn deficit in Q2 C$ bn 2 213Q3 213Q 21Q1 21Q2 21Q3 21Q 215Q1 215Q2 GOODS SERVICES INVINCOME OTHER TOTAL NBF Economics and Strategy (data via Statistics Canada) Foreign Direct Investment Other flows Portfolio flows Sources of financing was financed entirely by 5 short-term other flows Q3 213Q 21Q1 21Q2 21Q3 21Q 215Q1 215Q2 Current account deficit All told, the loonie s fundamentals remain weak not only due to low oil prices and a dovish central bank, but also because of a large current account deficit and the dependence on short-term capital flows. Complicating matters is the upcoming federal elections which promise to add a dose of uncertainty. We expect USDCAD to trade in the range through the end of next year.

5 Annex Euro Japanese yen British pound Canadian dollar Australian dollar Chinese yuan

6 ECONOMICS AND STRATEGY Montreal Office Toronto Office Stéfane Marion Chief Economist & Strategist Paul-André Pinsonnault Senior Fixed Income Economist Krishen Rangasamy Senior Economist Marc Pinsonneault Senior Economist Matthieu Arseneau Senior Economist Warren Lovely MD, Public Sector Research and Strategy General: National Bank Financial Markets is a business undertaken by National Bank Financial Inc. ( NBF ), an indirect wholly owned subsidiary of National Bank of Canada, and a division of National Bank of Canada. This research has been produced by NBF. National Bank of Canada is a public company listed on Canadian stock exchanges. The particulars contained herein were obtained from sources which we believe to be reliable but are not guaranteed by us and may be incomplete. The opinions expressed are based upon our analysis and interpretation of these particulars and are not to be construed as a solicitation or offer to buy or sell the securities mentioned herein. 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