Canadian dollar still offers room to trend higher

Karsten Junius May 31, 2021 08:52

The Canadian dollar (CAD) has made strong gains on the back of surging commodity prices. Year-to-date, the currency has gained around 5% against the US dollar and 6% in trade weighted terms. While reiterating our positive CAD view, we think the near - term technical picture warrants some caution as the USD-CAD pair continues to trade near oversold territory for now. Furthermore, the latest employment report came in a bit weak, reflecting renewed lockdowns amid a mounting third wave of Covid-19 cases in some Canadian provinces. Yet current net speculative positioning does not look stretched by historical standards.

Given the positive outlook for commodities and the Bank of Canada’s relatively hawkish policy stance, we believe that there remains substantial room for the Canadian dollar to trend higher throughout the second half of 2021.

Clearly, commodities have enjoyed a remarkable rally year-to-date. And with aluminum and copper prices at multi-year highs, commodity prices look stretched for now, particularly in the non-energy space. But given the substantial supply shortages in the global manufacturing chain, we think commodity prices are likely to advance further in the coming months. First, the limited supply is coinciding with relatively inelastic pent-up demand and second, it should take time to overcome the current supply-demand imbalance as production cannot be accelerated quickly enough to meet demand. This particularly applies to non-energy commodities such as sawn wood, an important Canadian export product that requires several months to produce. Hence, commodity tightness is unlikely to normalise before 4Q21.

While crude oil has also moved higher, its price uptrend has been subdued compared to the steep surge in non-energy commodity prices.

We believe oil would catch up throughout 2H21. So far, the re-imposition of lockdowns on the back of emerging virus variants, along with the heavily-hit global tourism sector, has weighed down on global oil demand. Yet we should see a major rebound of the service sectors once national vaccinations approach a more advanced stage in developed countries. Eventually, the normalisation of economic activity should boost oil and provide more upside for the Canadian currency.

Lastly, the Canadian currency also looks well-supported from a monetary policy side. Reflecting increased consumption on the back of fiscal stimulus packages at the federal and provincial levels along with strong foreign demand and higher commodity prices, the Bank of Canada (BoC) recently revised its 2021 growth forecast from 4% to 6.5%. Given these growth prospects and an April CPI print at 3.4%, the BoC adopted a more hawkish stance than most other central banks in the G10 space. As of April 26, the BoC has started to trim its bond purchases from a weekly minimum of C$4bn to C$3bn, and given the strong economic rebound, we should expect further reductions in bond purchases throughout 2H21. Furthermore, we expect the BoC to start hiking their policy rate as early as 2H22, which would be ahead of most G10 central banks, including the Fed. While the currency has likely priced these tailwinds to some extent, we think that there remains room for the Canadian currency to push higher towards year-end with both the BoC commodity price index and our longer-term model, based on government yields and commodities, supporting this thesis.

-- Contact us at [email protected]

Karsten Junius

Chief Economist, Head Economic Research at Bank J Safra Sarasin