This week's Bank of Canada meeting may signal that policy has reached an inflection point with the turnaround in data to see the BoC endorse a neutral bias. But we suspect it won't take much for the downside risks to re-emerge.
The strong reliance on export-led growth means that a weak CAD is crucial to the reflationary story. I wouldn't be surprised to see the BoC follow the Fed this week and strike concern over the tightening of domestic financial conditions.
As for USD/CAD, the near-term risks are still skewed to the upside and we could see a move back to 1.32 should oil prices drift lower. Yet, I think the pair will trade within a tight 1.32-1.38 range over a 3-6M horizon - with both the BoC and Fed arguably content with this stability. Fiscal thrust is likely to have a subdued impact on near-term growth, meaning that (future) monetary policy may be required to pick up the slack. With the uncertainty of the Trudeau government's first federal budget now lifted, there is a growing pressure on the BoC to clarify its policy stance at this week's meeting.
The annual revision to the central bank's output gap estimate will be the highlight of the latest MPR; it is perceived that the government's fiscal-stimulus will speed up the closing of the output gap. While on the surface, this reduces the need for the BoC to cut rates again, we believe that the potential benefits from such a fiscal thrust are only likely to be evident in the medium term.
Recent weakness in the trade data is a timely reminder that the central bank is still contending with the lagged effects of a severe oil price shock. While the likelihood is low, I do not rulvgar to shore up confidence and keep local monetary conditions easy. With the policy rate likely to remain on hold, front-loaded CAD weakness is even more crucial for a central bank deeply reliant on export-led growth. The Jan MPR revealed that net exports is expected to account for a sizable chunk of 2016 GDP growth. The 10% rally in the trade-weighted CAD since the 20 Jan meeting will be a concern for policymakers, although part of the strength can be justified by a recovery in oil prices (and risk sentiment).The repricing at the short-end of the CAD curve has also played a role, with the 2Y yield rising by 27bp since bottoming in mid-Jan. A more cautious BoC, one that follows the Fed in citing concerns of financial conditions, will see local rates (and the CAD) nudge lower.
Even if the BoC were to remain neutral, we see two reasons for why the near-term risks to USD/CAD are skewed to the upside: growing doubts over the durability of the oil price rally, and a correction higher in US rates (given the excessive sell-off). Oil prices have traded higher on the back of inventory drawdowns, seasonal demand and speculation that OPEC (Saudi Arabia) and non-OPEC (Russia) states may still reach an agreement to freeze output at this week's Doha meeting (17 Apr). Dwindling hopes of the latter is likely priced in and any failure to achieve this may take some of the steam out of the crude rally. A renewal of bearish oil bets will weigh on CAD. The Fed's renewed focus on US financial conditions has profound implications for our USD/CAD outlook. An important factor behind the tightening of US financial conditions in 2H15 was USD strength against the currencies of major trading partners. Given what we now know about the Fed's reaction function, a sharp move higher in USD/CAD is likely to be inconsistent with a hawkish Fed. We think the USD side (via higher US rates), may only give rise to modest USD/CAD upside at best.
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