EUR/CAD - Looking For A Perfect Match

|
Includes: FXC, FXE
by: Dmitry Lifatov

Summary

The biggest threat to the Canadian economy in the nearest term poses a growing probability of NAFTA talks breakdown;

Even on the assumption of healthy fundamentals in the Canadian economy, which indeed performs pretty well, this factor alone can cause a severe drop in CAD value;

The Euro, on the other hand, has all prospects for resuming its remarkable climb starting from the beginning of the next year;

Under such scenario, I target a 1.6200 level by the end of Q1 2018, with more upward potential in the next couple of months all the way to 1.6700.

The Canadian economy has adjusted to the depressed oil prices, and even more so, in 2017 it demonstrates the most significant growth among G7 countries [IMF sees Canada as top G7 economy; raises growth forecast - Article - BNN]. However, several factors spoil the whole picture, one of them is related to the internal macroeconomic situation, and the other one has an external origin.

I will start with the latter. In his recent interview at the Financial Post, Avery Shenfeld, chief economist at CIBC World Markets, put it even more strongly:

The only thing hanging over Canada's economy is one five-letter word, NAFTA.

Running NAFTA's negotiation race

Among the whole spectrum of Trump's pre-election economic initiatives, collectively known as "Trumponomics", none of which has been implemented up to date, by the way, one plan has the most likely prospects for translating into reality. Trump's threat to withdraw from NAFTA, in case of its implementation, has potentially profound and long-term implications for both Mexico and Canada. Although the broad consensus of economists has converged upon the more likely scenario of NAFTA reconfiguration, rather than the complete U.S. withdrawal from this free trade agreement, the probability of a failure of NAFTA renegotiations is pretty high, especially knowing the Trump's excessively harsh sharp-elbowed and extortionate style of negotiations, communicated via his appointed representative Robert Lighthizer, hardly compatible with the need for a systematic and careful discussion of all issues. In a nutshell, Trump, initiating NAFTA renegotiation process, targeted Mexico first of all. Judging from Trump's pre-election initiatives, such as his famous Border Wall project and an overall attitude to the Mexican immigrants, he is obviously not a great fan of this country, but in case of NAFTA, he had more "formal" reasons for concern, particularly, the U.S.-Mexico trade deficit. Canada, vice versa, runs a trade surplus with the U.S., but it was simply got caught in the crossfire.

In the period from the first round of NAFTA negotiations on August 16-20, 2017, till the end of the fourth round on October 11-17, 2017, the essence of talks on NAFTA reconfiguration can be expressed in one word - stalemate. The fifth NAFTA round in November 2017 witnessed some progress with these talks. I believe, however, that this progress was achieved partly due to a more technical agenda, which included less politically sensitive topics, such as textiles and intellectual property rights, which do not contribute too much to the U.S. trade deficit with Mexico, and partly due to a more effective team of negotiators comprised of trade experts and mid-level government officials in the absence of trade ministers. These two interrelated factors, which ensured a mild progress and sparked initial enthusiasm about negotiations eventually getting off the ground, make me doubt the future smooth and on-time finalization of NAFTA reconfiguration. I should remind that most of the so-called divisive topics, such as a sunset clause, auto rules of origin, and dispute settlement, which actually provoked this bargaining game, remain unresolved with no clear solution in sight. NAFTA renegotiation was inevitable sooner or later, as most experts agree, but exactly Trump's MAGA logic forced this speedy and unprepared negotiation race, which should be finished by the end of March 2018 - the final deadline before the start of a presidential election campaign in Mexico, which makes any further talks simply impossible. As it happens, impossible is nothing, and in the worst-case scenario the talks can be postponed till H2 2018, but the political situation in Mexico can change very radically, and no one can predict an attitude of a newly elected Mexican president towards NAFTA renegotiation process.

The return of Lighthizer and divisive topics into the agenda of the sixth round of NAFTA talks in January 2018 leaves little chances for a successful outcome. If the U.S. were able to exclude politically induced ultimative demands from the negotiation agenda with Mexico and Canada, I would say the whole process might turn positive. From a purely economic point of view, there is no special meaning in rushing with this deal. Moreover, currently, there is no in-depth analysis, quantifying economic consequences for the U.S. withdrawal from NAFTA. Many experts studied separate aspects of a probable impact, but no one calculated an overall cost of NAFTA dissolution for the U.S. economy. That is why, as I see it, the most preferable scenario for the U.S. in such case will be a gradual "technicalization" of the negotiation process, which involves removal of the so-called "poison pills" from the talks agenda, and more clear focus on other less sensitive themes at least for some time now, incentivizing structural changes in NAFTA via longer-term economic carrot-and-stick approach, not through a primitive extortionate bargaining. However, with time counting down for Trump as the U.S. President and no single pre-election promise still being implemented after more than 300 days in office, it is very difficult to predict his future actions amid an "I-need-to-do-something" paradigm.

For Canada, generally speaking, there are five key NAFTA issues, which prevent an effective dialogue from taking place with the U.S. Although none of them is unmanageable, we should understand that the success of NAFTA renegotiations depends very much on the compliant behavior of the Mexican side. Trump has already said that he is open to a bilateral Canada-U.S. trade deal in case of NAFTA's failure, but currently Canada has also rather weak negotiation positions, taking into account its oil export dependency on the U.S., and I assume, the Canadian negotiators will wait until the very last moment to understand whether trilateral agreement could be reached or not. Only afterwards, if Mexico refuses to surrender to the U.S. demands and drops out of negotiations, Trudeau and Trump can strike a bilateral deal, which will be more or less beneficial both for Trudeau from an economic point of view, and for Trump, who will be able to minimize his reputation damage, at least to some extent.

In practice, failure to negotiate some sort of NAFTA reconfiguration by the end of March 2018 almost certainly means at least limited drops in CAD value. I assume, traders will not wait for an official announcement of negotiation results in March 2018, but will react in some way already starting from the sixth round of talks on January 23-28, 2018 in Montreal (Canada), depending on the achieved progress. The more signals will come from Montreal proving an ultimate stalemate in talks, the more downward pressure on the exchange rate of CAD will be exerted.

Canada's macroeconomic outlook

Another negative factor, which I mentioned at the beginning of my article, is related to a slowdown in the Canadian economy. Although we know that the Canadian economy demonstrated some signs of overheating in H1 2017, with a lengthy string of upbeat economic data at that time, in H2 2017 it started to cool down. The leading macroeconomic indicators are already trending in different directions. Manufacturing PMI in October 2017 fell to 54.3, down from 55.9 in April 2017; whereas business confidence increased to 63.8 in October 2017, which is slightly higher than the mid-year values; and consumer confidence posted even more solid gains, 55.37 in November 2017, up from 50.2 at the beginning of the year [hereinafter, if not stated otherwise, all data come from TRADING ECONOMICS | 20 million INDICATORS FROM 196 COUNTRIES].

The coincident macroeconomic indicators, however, do not indicate any serious problems. Though the CPI index fell from 2.1% y/y in January 2017 to 1.4% y/y in October 2017, a clear bottom occurred yet in June this year, with a mild 1% y/y CPI increase marking the slowest pace of price gains in Canada since October 2015. In his speech to CFA Montréal and the Montreal Council on Foreign Relations on November 7, 2017, Stephen Poloz, Governor of the Bank of Canada (BOC), stressed two temporary one-off factors, which dragged prices lower in Canada in H1 2017. According to his view, a CPI shortfall in the first half of the year can be explained by "below-average food inflation caused by a combination of abundant crop supplies and increased competition in the retail sector… and by the impact of the Ontario government's reduction in electricity prices". Nevertheless, starting from July 2017, consumer inflation has been showing signs of revival, largely due to an increase in gasoline prices and a steady house-price growth in major cities. Producer prices demonstrated a slightly different dynamic, reaching a clear peak in April 2017 with a solid 6.4% y/y increase, but falling afterwards to 1.8% y/y in October 2017. Wholesale inflation in Canada remains largely subdued, bouncing up and down in a tight range since July 2017, but is expected to mirror the CPI trend shortly. The unemployment rate in Canada in October 2017 amounted to 6.3%, down by 0.5% since the beginning of the year. The Canada's GDP growth rate is flattening, especially as compared to H1 2017, but still is pretty healthy despite a 0.1% contraction in August 2017. Taking into account the recent IMF projections for the Canadian economy in 2018, which forecast the second fastest growth rate among G7 countries around 2.1% y/y, I do not expect any significant headwinds from this side.

Among more or less important Canadian macroeconomic data, I can highlight only two main issues, which might turn negative in the long-term under specific conditions. The elevated level of Canadian household indebtedness and imbalances in the Canadian housing market are considered as two biggest vulnerabilities in the Canadian economy, according to the recent BOC's report. Now their significance is largely alleviated by a combination of a still-strong economic growth and yet affordable interest rate, but should it change, this might trigger potentially unhealthy consequences for the whole Canadian economy.

Therefore, two most important indicators, we should carefully watch over the next couple of months, include GDP growth rate and interest rate hike schedule. The next BOC's interest rate announcement will take place on December 06, 2017. Stephen Poloz has already warned that the next cycle of rate hikes will be very much data-dependent, and by no means automatic given the predetermined path. The BOC started a new cycle of monetary policy tightening in July 2017 amid an increasingly positive economic environment, but from my point of view, this time for the BOC, given the uncertainties surrounding NAFTA talks, it would be much better to take a pause in interest rate hikes under a "wait-and-see" approach.

The brightest star so far

I believe, on a 2-3 month time horizon, the optimal counterpart currency for the Canadian dollar might be euro. The Eurozone is currently the brightest star on the world economic arena. As we see from a fundamental point of view, little has changed for the European currency since the start of its remarkable appreciation in April 2017. The Eurozone leading macroeconomic indicators - Manufacturing PMI, Services PMI, as well as business and consumer confidence - run extremely positive. Its Markit Manufacturing PMI's values in November 2017 stood at the highest level in the whole period of observations in 2007-2017, ensuring the first place of the Eurozone in the rating of top Manufacturing PMI performers in the world. The values of the Euro Area Business Climate Indicator in October 2017 are also close to their historical highs (+1.44 in October 2017 as compared to an all-time high of +1.53). Consumer confidence has been also progressively improving throughout the year.

Most of the underlying coincident indicators are also improving. One of few exceptions is consumer inflation, which is stubbornly low despite massive and prolonged QE injections, bouncing around a 1.4% y/y level for already six consecutive months. With CPI still well below a 2% target, there is an uncertainty over the exact date for ending the QE program, although the recent ECB minutes showed a shift towards a gradual movement away from the mandatory requirement of a sustained rise in inflation as a pre-condition for removing ECB stimulus. This increases a probability of QE's end in 2018 even in the absence of a clear uptake in CPI values. If the ECB Governing Council moves this way more vigorously, it will probably provide a strong support to Euro. All other inflation rates - core CPI, PPI, etc. - also remain weak. The unemployment rate in the Euro Area in September 2017 stood at the level of 8.9%, down from 9.6% at the beginning of the year. The Euro Area GDP Annual Growth Rate in Q3 2017 expanded by 2.5%, which is also a clear improvement as compared to the January's readings of 1.9%. Interest rates in the Eurozone are expected to remain at 0 at least till 2019.

Conclusion

To sum up, (1) we will almost certainly see growing difficulties with NAFTA renegotiation process, which must be finalized by the end of March 2018. This means, that the Canadian dollar will experience strong downward pressure, even on the assumption of the healthy fundamentals in the Canadian economy; (2) on the other side, I do expect a continuation of the Euro's ascend at the beginning of the next year. Taking into account all the above, I suppose EUR/CAD may pose rather lucrative growth opportunities within a 2-3 month time frame. Technically, a successful break above a 1.5200 weekly resistance level will open up advance to 1.6200 (equivalent to a 6.5% growth), with the final target near an upper boundary of the ascending trend channel, which can be visualized on a monthly time frame, around 1.6700.

Disclosure: I/we 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.