Why Isn’t the Canadian Dollar Getting Stronger?

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There have been two major events recently that typically would have led to bets that the loonie would get stronger. The price of Canada’s main export keeps rising, and the most recent inflation data shows an uptick. Why aren’t investors piling into buying Canadian dollars?

The quick explanation is that there hasn’t been much appetite for risk. US Treasuries offer a relatively fantastic yield, and have been gobbling up a lot of the free cash available. US money markets are rising along with yields, as people move cash from riskier assets to make a no-risk 5% annual in holding US bonds.

But, that’s not the whole story

Canada is also facing some particular challenges, and that relates to BOC policy. The general expectation is that the BOC won’t raise rates anymore. That normally wouldn’t be an issue, given that the consensus is the Fed won’t raise either. The interest rate spread in the short term is expected to remain the same.

The problem is that Canadian inflation has been rising, while the US is expected to see inflation to continue downward. That means the real rates are in favor of the Americans, since less of the return is lost to inflation. On top of that, if US inflation were to pick up, there is a pretty solid conviction that the Fed wouldn’t hesitate to raise rates again. With the Canadian economy stagnant at best, the BOC has much less leeway to raise rates. In fact, the chances of a rate cut in the medium term seem to be much more likely than in the US. Therefore, the balance of risk for the Canadian dollar is to the downside.

But what about the price of crude?

Prices for crude have been rising, but thanks to voluntary production curtailment by Russia and Saudi Arabia. Both countries could, theoretically, reverse those curbs at any moment, with no need for an agreement with other producers. That means the current rise in prices is shaky at best.

Forecasters see crude prices ending the year in the upper $80s per barrel, which is lower than the recent price spikes. The expectation of higher prices is driven by forecasts of global economic growth that will push demand above production. But the world’s largest crude importer is seeing its economy face significant headwinds. More directly related to Canada, its largest crude buyer is seeing relatively high prices at the pump.

Slowing demand, and a rebound?

Last year, US consumption of petroleum was under pressure due to higher prices, which caused Americans to forego some leisure driving. As prices rise back to the levels seen last year due to higher crude prices, demand could start leveling off. And demand naturally reduces going into autumn, anyway. The recent price increases in crude, therefore, might be limited.

The other factor is the high cost of home loans in Canada is seen as a major drag on the economy. Unlike in the US, Canadian homeowners primarily have adjustable rate mortgages, and if the BOC persists in rising rates, it could have a bigger impact on the economy. And if the housing market suffers a significant drop, the BOC might be forced to cut rates.

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