Why USDCAD Could U-Turn on Bank of Canada Announcement

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Why USDCAD Could U-Turn on Bank of Canada Announcement

Daily FX Market Roundup Jan 7, 2019

Of all the major currencies, the Canadian dollar performed the best in these first few days of 2019. Between January 2nd and January 8th, USD/CAD dropped 2.5%, giving up a third of the past 2 months gains. A strong labor market, decline in the U.S. dollar, recovery in risk and rebound in oil prices all played a role in the pair’s steep decline but the move could come to a screeching halt after tomorrow’s Bank of Canada’s monetary policy announcement. Although economists do not expect the central bank to raise interest rates, the recent performance of the currency tells us that a number of investors expect the central bank to recognize the incredible strength of the labor market and the support that this provides for the economy.

Unfortunately Canadian dollar bulls may find themselves disappointed by the BoC who altered their outlook significantly in December. After raising interest rates in October, the BoC had the market looking for more tightening when they said interest rates needed to rise to neutral levels. However after a more than 20% drop in oil prices and wild swings in equities, the central bank dialed back their optimism and warned that risks to growth shifted from the upside to the downside. They felt that the energy sector could be materially weaker than they had previously thought, which implies that the move to neutral can wait. Oil prices are off their lows and stocks are rebounding for the third day in row but all of the market indices are still lower than where they were on December 5th when the central bank last met.

The problem is that the rest of the economy is not reaping the benefits of the labor market. Despite strong job growth in November and continued hiring in December consumer spending growth is very slow. Inflation is trending lower and the recent rate hikes is taking a toll on the housing market activity. Manufacturing and trade activity is also suffering hard from U.S. tariffs, the weaker currency and lower oil prices. So while the Bank of Canada has less to worry about now than late December, when stocks and oil were crashing, the improvements are too new for the central bank to alter their outlook again.

Aside from an interest rate decision, the Bank of Canada will also release their monetary policy report and latest economic projections. This will be followed by a press conference from Bank of Canada Governor Poloz and Senior Deputy Governor Wilkins. There will be plenty of opportunity for the central bank to clarify their outlook and pave the way for the next big move in USD/CAD. If the BoC emphasizes the painful adjustment in Western Canada and the impact on the overall economy over the need to bring rates back to neutral which is somewhere between 2.5%-3.5%, USD/CAD will reverse its slide and rebound in a move that could take the pair back to 1.34. However if the recent stability is enough to embolden the central bank to say that the next move in rates will be higher, USD/CAD could slip down to 1.3180.

Otherwise it was a relatively quiet day in the FX market with currencies trading in relatively narrow ranges during the NY session. The only exception was sterling, which erased all of yesterday’s gains after the UK government lost a vote that would help to prepare for a no-deal Brexit. MPs supported a measure that limits spending on no-deal preparations unless authorized by Parliament. Not only does this reflect May’s weakened power but also makes the government less prepared to leave the European Union with no agreement on March 29. With each passing day, the risk for sterling increases – unless there’s some good news, GBP/USD is likely to drop back to 1.26.

There was no U.S. economic reports released today but tonight the President will hold a national address on the government shutdown and border wall which will be followed by a response from Pelosi and Schumer. It will be an interesting night in US politics but aside from trading jabs and accusations on who is holding back the government from reopening, we don’t expect any meaningful announcements for the economy and markets. Instead, the FOMC minutes due Wednesday should cap gains in the greenback because the details from the last policy meeting will focus on the central bank’s concerns. Weaker than expected economic data contributed to the decline in the euro and Australian dollar. For euro, the steepest decline in German industrial production since December 2016 and the general pullback in sentiment make it difficult for EUR/USD to break 1.15. AUD was hit by a smaller than expected trade surplus and we don’t expect much help from tonight’s service sector PMI report.

Kathy Lien
Managing Director

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