On January 22, 2014, the Bank of Canada left its target overnight interest rate at 1%. However, the Canadian dollar (FXC) slid quickly against the U.S. dollar anyway as the currency continues a run toward my 1.16 target (on USD/CAD) at a clip much faster than I expected. After losing about 6.5% against the U.S. dollar last year, the Canadian dollar has already lost another 4.6% in the month of January.
A 16-month slide accelerated in January, 2014
I read through the detailed Monetary Policy Report accompanying the press release and watched the press conference for confirmation of an increasing dovishness in tone from the Bank of Canada. The Monetary Policy Report tells enough of the story, so the rest of this review focuses there.
The most striking part of the report is the outright bullishness on the U.S. economy, the optimism for the global economy, and the very measured commentary on the Canadian economy. One of the Bank's key observations: "Global economic growth is expected to strengthen over the next two years, led by stronger momentum in the United States."
Comparison of real GDP growth, annual data, shows the U.S. surging ahead
I believe the Bank of Canada's assessment is a consensus one. It helps me understand why financial markets rumble these days anytime growth in the U.S. is called into question.
The Bank's forecast for global growth is essentially unchanged from the last Monetary Policy Report in October: forecasted 3.4% for 2014 stays the same and forecasted 3.7% for 2015 is up from 3.6% in the October report. The Bank includes results from a survey that supports optimism on global prospects:
"The results of the latest survey conducted by Export Development Canada show that for the first time since the spring of 2011, the balance of opinion regarding global economic conditions is positive, and that firms are more optimistic about international business opportunities."
The U.S. gets a significant upgrade for 2014 from 2.5% to 3.0%. This pulls a small amount of growth from 2015 as that forecast drops to 3.2% from 3.3%. The projection for Canadian growth gets a slight upgrade for 2014 from 2.3% to 2.5%, "underpinned by the ongoing firming in the U.S. economy." Projected growth for 2015 goes down slightly from 2.6% to 2.5%. In other words, Canada benefits from the upgrade in growth for the U.S. but not quite as much as the U.S. itself benefits.
The Bank of Canada's explanation for the U.S. economic expansion highlights the Bank's bullishness on the U.S.:
"A projected broad-based acceleration in U.S. private demand over 2014−15 is expected to create a virtuous circle of self-sustaining growth. Growth in consumption is expected to pick up, supported by strengthening labour market conditions, continued increases in household wealth and improved access to credit. Even with higher mortgage interest rates, the recovery in the housing sector is projected to continue at a solid pace as bank lending conditions are eased, household formation rebounds and the stock of homes in foreclosure declines. In addition, the growth of business investment is anticipated to increase, given improving economic conditions and less uncertainty about fiscal policy. A robust rise in exports will likely be more than offset by an increase in non-oil imports, with net exports making a slightly negative contribution to real GDP growth over the projection horizon."
(As an important side note to the Bank's bullishness on U.S. housing, the report includes a forecast for higher lumber prices "…supported by the ongoing recovery in the U.S. housing sector. I consider these forecasts to be additional validation for my bullish expectations for U.S. housing in 2014).
The Bank's ruminations on potential upside surprises for the U.S. economy are even more telling:
"There is a risk, however, that U.S. economic growth could surprise further on the upside if businesses increased investment spending more rapidly than projected in response to reduced policy uncertainty and a rekindling of 'animal spirits.' Such a scenario would have broad positive spillover effects on the global economy."
Contrast this "warning" with the risk the Bank of Canada sees for the Canadian economy: "there is a risk that the recovery in non-commodity exports may take even longer than anticipated, given ongoing competitiveness challenges and potential supply constraints."
Moreover, the Bank of Canada sees a continued risk in a "disorderly unwinding" in Canada's housing market:
"Households remain vulnerable to adverse economic shocks, however, given that household leverage remains elevated and the ratio of house prices to income is close to its all-time high. The risk of a disorderly unwinding of household sector imbalances, should it materialize, could have sizable spillover effects on other parts of the economy and on inflation."
Even a positive upside surprise specific to Canada is linked to improvements in the U.S.:
"The major upside risk to inflation in Canada is the possibility of stronger-than-expected growth in U.S. private demand. Stronger U.S. demand would be transmitted to the Canadian economy through the trade channel and firmer commodity prices, as well as through reduced uncertainty and positive confidence effects."
During the Q&A portion of the press conference, Governor Stephen S. Poloz pronounced multiple times that the balance of risks for Canada are more tilted to the downside. Poloz would not commit to a dovish or hawkish bias; instead, he is firmly neutral.
The separation in expected growth rates between the U.S. and Canada could by itself explain much of the market's repricing of the USD/CAD currency pair. Indeed, the Bank cites improving growth prospects in the U.S. (along with reduced safe-haven buying) as a reason for the depreciation of the Canadian dollar. But there is more.
Inflation in Canada "has continued to surprise on the downside in recent months." The Bank cites "significant and persistent slack in the Canadian economy" as a core reason for surprisingly weak inflation. The Bank additionally warns that "it is also possible that the level of economic slack is greater than currently estimated." While inflation is surprisingly low through the world's advanced economies, the situation in Canada is forcing a readjustment in expectations.
Inflation remains well below targets across major economies
Most telling are the comments about the currency indicating that the exceptionally strong Canadian dollar was hurting Canada's economic performance and that further depreciation promises several benefits (this is one of the main points I argued last April which set-up my long-standing bearishness on the Canadian dollar)…
"While as yet there are no signs of a rebalancing toward exports and business investment, the strengthening of the global economy and recent depreciation of the Canadian dollar should foster a broadening of the composition of growth in Canada…The stronger performance in the trade sector should be supported by the depreciation of the Canadian dollar in recent months."
The strong Canadian dollar has been largely responsible for the lack of rebalancing, and it remains a problem:
"…the Canadian dollar remains strong and will continue to pose competitiveness challenges for Canada's non-commodity exports."
In other words, do not expect the Bank of Canada to do anything that might drive the currency higher or stop it from depreciating further. I think the 1.16 target for USD/CAD remains very realistic. At the current pace of depreciation, USD/CAD could hit this level "ahead of schedule."
Be careful out there!
Disclosure: In forex, I am long USD/CAD. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.