My re-evaluation of my newfound bullishness on the Canadian dollar came just in time for a surprise rate cut from the Bank of Canada (BoC). The CurrencyShares Canadian Dollar ETF (NYSE:FXC) plunged 1.8% to a fresh, near 5-year low on news that the BoC decided to cut its target overnight interest rate target from 1% to 0.75%.
The accelerated decline is becoming more and more familiar in financial markets these days: this time it is the CurrencyShares Canadian Dollar ETF
While I have noted in the past the increasing dovishness from BoC governor Stephen S. Poloz, I did not expect a rate cut at this meeting. If anything, I thought this meeting might set the stage for such an action after the market had a chance to absorb the implications of the January 2015 Monetary Policy Report.
The decision essentially came down to the disinflationary impact of falling oil prices:
This decision is in response to the recent sharp drop in oil prices, which will be negative for growth and underlying inflation in Canada…Total CPI inflation is starting to reflect the fall in oil prices.
However, the BoC is NOT bearish on oil (NYSEARCA:USO) or on growth. The Bank's baseline case for oil prices is $60 per barrel. This projection comes from the Bank's convention to assume that future prices will average around the existing short-term average. Brent crude has averaged $60 since December. The Bank recognizes that the current price is much lower but expects a rise to occur over the medium term: "Overall, the Bank views the risks to the US$60 price assumption to be tilted to the upside over the medium term." That assumption forms a basis for the BoC's expectation for total inflation to return to its 2% target next year.
The Bank of Canada expects a relatively brief bout of disinflation
The Bank also believes that the "backdrop" of growth is strong despite the oil-driven headwinds:
The oil price shock is occurring against a backdrop of solid and more broadly-based growth in Canada in recent quarters. Outside the energy sector, we are beginning to see the anticipated sequence of increased foreign demand, stronger exports, improved business confidence and investment, and employment growth. However, there is considerable uncertainty about the speed with which this sequence will evolve and how it will be affected by the drop in oil prices. Business investment in the energy-producing sector will decline. Canada's weaker terms of trade will have an adverse impact on incomes and wealth, reducing domestic demand growth.
The uncertainty around the impact of oil prices is what interests me the most. Earlier, the Bank of Canada promised to answer such questions in its the January 2015 Monetary Policy Report. The report could not be more clear on its assessment of oil's net negative impact on the Canadian economy:
The considerably lower profile for oil prices will be unambiguously negative for the Canadian economy in 2015 and subsequent years.
When I concluded that an imperfect relationship existed between oil and the Canadian dollar, I looked at the inconsistency of the correlations and the relatively small percentage of the Canadian economy directly dependent on oil. The Bank of Canada calculated a broader impact:
Oil and gas extraction accounts for only about 6 per cent of GDP, but movements in oil prices have a significant impact on the Canadian economy. This is due, in part, to the importance of investment in the oil and gas sector, which makes up about 30 per cent of total business investment. Moreover, since Canada is a net oil exporter, oil prices have an important effect on domestic incomes and the Canadian dollar.
The BoC went on to describe specific ways in which the oil shock propagates beyond Canada's oil-producing regions:
- "Lower labour demand and wages in the oil sector spill over into other sectors and regions to some extent.
- Weaker profits in the oil sector adversely affect the investment portfolios of Canadians in all parts of the country.
- Interprovincial trade spreads the effects of a slowing oil sector. For example, estimates suggest that nearly one third of the employment effects from the oil sands on the domestic supply chain occur outside Alberta.
- Federal fiscal policy attenuates disparities in the impact of oil-price movements on different regions."
In general, I think these are very indirect impacts. Apparently they are sufficient to cause the Bank of Canada great concern. Still, the largest impacts are the direct ones (emphasis mine):
In the near term, real GDP growth is expected to slow to below the growth rate of potential output, and the unemployment rate is expected to rise as investment in the energy sector rapidly contracts in response to lower oil prices and as housing market activity in energy-intensive regions slows.
Lower oil prices reverse roughly one-third of the income gains associated with the improvement in Canada's terms of trade since 2002, which will weigh on consumption and public finances over the projection horizon.
That reversal in incomes is pretty significant. A good portion is driven by the rapid contraction in investment by energy companies. I can only imagine the depth of the planned response helped convince the BoC of the necessity of a rate cut:
Interviews with energy firms conducted by Bank staff in November and December 2014 suggest a relatively quick investment response to lower oil prices, with firms already scaling back projects planned for 2015. The near-unanimity with which energy companies, even large ones with long-life projects, cited short-term energy prices as the key factor driving capital plans reflects the unexpected speed and magnitude of the oil-price decline.
Overall, the anticipated decline of close to 30 per cent in investment spending in the oil and gas sector during 2015 reflects a recalibration of firms' expectations for oil prices for the current year and beyond. In November and December, many firms held the view that oil prices would recover over the medium term this expectation is preventing an even larger drop in investment intentions.
With the natural uncertainty in any forecast, the BoC has to worry about the potential for a much greater retrenchment should current expectations on oil prices still prove overly optimistic.
The estimate negative economic of a range of oil price scenarios
Shining through all these concerns is the U.S. economy. Once again, the BoC is expecting good things from the U.S. that will in turn help bolster the Canadian economy through exports (emphasis mine):
The negative impacts of weaker oil prices for the Canadian economy will be gradually offset over the projection horizon by other effects of the price change, including the net positive impact on the global economy, and especially on the United States, and the depreciation of the Canadian dollar…
Economic growth in the United States is expected to become increasingly self-sustaining, further propelled by the large positive impact from oil-price declines, despite the drag from the appreciation of the U.S. dollar…
The decline in oil prices will provide a further boost to economic activity. The estimated impact of a decline in oil prices from the June 2014 level of about US$110 to the base-case assumption of US$60 would be to raise the level of U.S. GDP by about 1 per cent by the end of 2016. Overall, the combination of the recent stronger-than-expected U.S. growth and lower oil prices, partially offset by the appreciation of the U.S. dollar over recent months, results in a more positive outlook for the U.S. economy than anticipated in the October Report…
Stronger-than-expected private demand in the United States is the most important upside risk to inflation in Canada.
The BoC is also looking forward to some positive feedback from global growth driven by lower oil prices, moderated by the negative impacts on other oil-producing countries. The BoC's net optimism on global growth comes from a conclusion that the oil shock is more of a supply-side issue. After comparing the price action across multiple commodities, the BoC concludes "these price movements have generally been less pronounced than those observed in oil markets…suggesting that recent shifts in global demand are not the driving force behind the large movements in oil prices."
The BoC also expects consumers to direct some of their oil savings to paying down debt as part of an on-going deleveraging process in the economy.
A weaker Canadian dollar is the mechanism through which economic strength in the U.S. will translate into stronger economic performance in Canada. First, the fall in oil prices helps drive the Canadian dollar lower. Second, the weaker currency helps drive better performance in the non-energy sector.
Investment in Canada is financed by both domestic and foreign capital. Reduced investment leads to a drop in the net inflow of foreign capital, which, together with lower oil export revenues, causes the Canadian dollar to weaken. Other things being equal, the weaker exchange rate further aggravates the adverse impact on investment by making imported goods more expensive. However, the exchange rate adjustment also makes Canada's non-energy exports more competitive in international markets, which boosts sales and, eventually, investment.
The Canadian dollar participates in a dynamic adjustment process. The drop in oil shifts money away from the energy sector where the oil-induced currency depreciation makes opportunities more attractive. This adjustment is well underway as demonstrated by the earlier quote about the growing success seen in the non-energy sector.
The Bank of Canada's rate cut should further support this adjustment as the Canadian dollar continues to weaken in the aftermath of the monetary policy decision: "The recovery in non-energy exports is expected to continue over the projection horizon, with exports stimulated by the lower Canadian dollar and stronger foreign activity."
The Bank of Canada is quite cognizant of the economic benefits of a weaker currency
In earlier pieces, I relied on surprisingly strong labor reports as part of an increasingly bullish thesis on the Canadian dollar as a contrarian play. It turns out that the BoC looks at a different measure of the health of the labor market called the Labour Market Indicator (LMI). As the graph below demonstrates, LMI did not improve along with the unemployment rate in 2014:
Despite a falling unemployment rate in 2014, the overall health of the Canadian labor market has yet to improve from 2012 levels
Apparently, the LMI takes into account factors like long-term unemployment, average hours worked, wages, participation rates, and the proportion of the labor force stuck with involuntary part-time jobs. I have duly noted to track THIS measure more closely than the unemployment rate alone.
The Canadian dollar was not the only currency impacted by the BoC's rate cut. The Australian dollar (NYSE:FXA) also plunged as traders likely concluded that the BoC's commodity-driven reasoning will next be emulated by the Reserve Bank of Australia (RBA).
The Bank of Canada's oil-driven rate cut ends the Australian dollar's relief rally
The BoC decision certainly sets the stage for the RBA to finally cut rates in February's decision on monetary policy. The market expectations for such a cut soared:
Market odds for a February rate cut jumped from 22% to 31%
Source: ASX RBA Rate Indicator
I think these odds are far too low. The Bank of Canada's action all but ensures the U.S. Federal Reserve will see little reason to hike rates at all this year. Assuming the RBA makes the same conclusion, it will have to drop its hope that the U.S. dollar will do all the work of currency depreciation for Australia.
Be careful out there!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: In forex, I am short the Australian dollar and will likely return to a bearish bias on the Canadian dollar (looking for follow-through to the latest weakness)