Morgan Stanley: Canadian Dollar Could Be at Risk

The Canadian economy is likely to experience a deeper and longer slowdown than previously thought, according to Charles St-Arnaud writing in Morgan Stanley's latest Global Economic Forum, and this is likely to impact on USD/CAD.

The latest Canadian GDP figures confirm that, while on the one hand, external demand is weak and the strong Canadian dollar is dragging the economy down, on the brighter side, the domestic economy is buoyant, this due principally to a strong labor market, increased purchasing power and strong income growth. However weaker global growth in 2008 will have repercussions for an economy where exports account for 35% of GDP. St-Arnaud sees consumer spending remaining solid, albeit moderating more than previously expected, while business investments too are likely to moderate.

Overall, the Canadian economy should grow by 1.2% in 2008 and 1.9% in 2009, in my view, compared to 1.7% and 2.6% previously. (Some of the downward revision to growth in 2008 comes from the weaker-than-expected GDP growth in 4Q07.) I expect growth to be weaker throughout 2008 and the rebound to be in early 2009 instead of 2H08. As a result of weaker growth, inflation will likely be lower in 2009, in my view.

In the context of slower global and Canadian growth, an uncertain global outlook, lower inflationary pressures and continued financial market turbulence, I believe that the Bank of Canada will continue to cut rates aggressively. I now expect the BoC to cut rates by 50bp at the April meeting and by 25bp at the subsequent meetings, reaching a level of 2.75% in 2Q. I also expect the BoC to continue to provide liquidity to the market via normal and term purchase and resale agreements. I have warned in the past that the BoC may have to reverse some of the cuts sooner rather than later, but this has now been pushed to early 2009.

However the Canadian dollar is vulnerable in the medium term, according to St-Arnaud, impacted both by an appreciation in the USD and lower commodity prices. As St-Arnaud explains:

The expected USD rebound later this year will likely be broad-based, and we will likely see USD/CAD move higher as a result. In addition, given the relationship presented previously, an appreciating USD could mean weaker commodity prices. Given the very strong link between the CAD and commodity prices, this would put further upward pressure on USD/CAD. Further, according to our fair value models, USD/CAD is currently undervalued, which should support the move. Therefore, USD/CAD is at risk of moving sharply higher. This is, in part, what happened last week, when USD/CAD gained more than 3% in two days. I agree with our strategy team, which is recommending a long USD/CAD position partly on these arguments.

Comments

[bill d]

Not to worry - Meredith will bail them out !