Investors are selling Canadian dollars aggressively this morning on the back of the Bank of Canada’s monetary policy announcement. While the central bank left interest rates unchanged at 1%, their growing concern about low inflation and desire to see their currency weaker has sent USD/CAD to a fresh 4 year high above 1.10. Here are the 3 main takeaways from the BoC statement:
Main Takeaways from Bank of Canada Statement
1. Not worried about 6% drop in CAD since Oct
2. Downside risk to Inflation has increased
3. Outlook for 2014 growth brighter but softer 2015 growth
Despite a 6% drop in the value of the Canadian dollar versus the U.S. dollar since October, the central bank still thinks the currency is too strong. They need it to fall further because they want more support for the export sector. Canadian trade activity deteriorated significantly in October and November with export volumes to the U.S. falling. Part of the reason why the central bank can tolerate a weaker currency is because they believe that the “downside risk” to inflation increased and to reinforce this view, they cut their 2014 inflation projections. While Finance Minister Flaherty, the OECD and the IMF feel hat the Federal Reserve’s plans to scale back asset purchases increases the risk of inflation in Canada by driving the U.S. dollar higher and the Canadian dollar lower, the BoC feels that retail competition is pushing down inflation. The latest consumer price report shows inflation running at an annualized rate of 0.9% in November. Interestingly, the BoC raised its growth outlook for 2014 from 2.3% to 2.5% but cut their 2015 outlook to 2.5% from 2.6%. In other words they don’t expect any major acceleration in growth in 2014 and 2015.
By notching down their inflation outlook and saying that the currency is too strong, the Bank of Canada strengthened their easing bias. While we don’t expect the central bank to cut rates in 2014 unless the housing market crashes, they will not succumb to the pressure to raise rates. With economic data deteriorating significantly since the December meeting, Poloz is recognizing the downside risks to the economy and the need to keep monetary policy very easy. Manufacturing activity contracted at its fastest pace since May 2009, job losses hit the highest level in 9 months and the unemployment rate rose to a 5 year high but the biggest risk for Canada this year is the housing bubble. According to a recent report from the OECD, Canada’s house prices are 60% higher than their long term average on a price to rent basis. Rising prices pushed consumer debt levels to a record high of 163% with the average Canadian household spending more than 30% of their incomes on housing. Unlike the U.S. where house prices corrected steeply in 2008, the drop in Canadian house prices was shallow. Since the global financial crisis, house prices in Canada have increased another 20%. The amount of construction underway is significant and with more than 13% of jobs in Canada linked to construction, a crash in the housing market would have broad ramifications for the overall economy.
It is almost hard to believe that back in September, the central bank was talking about raising rates and with today’s announcement, the market will price in a greater chance of a rate cut, although we still think odds are less 30% this year. The last time the BoC changed monetary policy was in September 2010. Since the beginning of October, the Canadian dollar lost over 6% of its value against the U.S. dollar, euro and British pound. While we haven’t seen inflation rise as a result of the weaker currency, eventually it would boost inflation and activity.
The biggest risk to the USD/CAD rally is speculative positioning. According to the latest CFTC IMM report, speculative short positions are at their highest level since May 2013 and also at extreme levels on a historical basis. This means that in order for USD/CAD to extend higher, Stephen Poloz needs to reinforce this dovishness when he speaks at 11:15am ET.