Summary: Our qualitative view of the Canadian dollar exchange rate is broadly in line with the Interchange Financial Consensus Forecast. The Canadian dollar will be largely rangebound but strengthen modestly over time.
The end of the health crisis caused by the pandemic is not near, but it is in sight. By now, given developments around vaccines and some treatments, it is fairly clear that we will begin seeing an improvement in the Spring of 2021. However, the economic consequences of the crisis remain to be determined. Nonetheless, there are some developing themes about the Canadian dollar in the next few quarters that can be assessed now.
At the onset of the pandemic, nearly every measure of economic activity fell by record amounts as a result of the unprecedented halt in the economies of much of the world. In the financial markets, all “risky” assets sold off as investors and traders moved to safe-haven assets. This meant that stock prices declined, bond yields tightened, and oil sold off. It also meant that the safety of the US dollar became very attractive and the Canadian dollar declined by nearly 10%.
The acute phase of the economic crisis did not last long. Governments and central banks in most of the developed world responded with extraordinary stimulus efforts. In Canada, these efforts dwarfed anything that has been observed in the recent past, including the response to the 2008 economic crisis. The Federal Government moved to put dollars directly in the pockets of consumers and businesses. The Bank of Canada initiated a range of programs intended to inject liquidity into markets and keep borrowers and lenders afloat by keeping rates near zero.
Both in Canada and in the rest of the world these measures worked to stave off large-scale economic hardship. More than that, the global (and Canadian) economy rebounded stronger than most people expected, recovering most of the lost economic activity. The markets reacted as well. Stocks rebounded and the Canadian dollar rose to pre-pandemic levels as the fear of the worst-case outcomes receded. By most measures, we were seeing a V-shaped recovery.
As we were entering the “grind-out” phase of economic recovery which might have seen us recover the difficult last bit of lost economic activity, the second wave of the coronavirus hit. In Canada, the US, and most of Europe, the second wave has turned out to be worse than most people imagined. However, the second wave has led to different economic consequences than the first phase. This time, stock markets have been rising to record levels, oil prices are firm and rising, and a relatively stable Canadian dollar is trading in the middle of the range of its pre-pandemic levels.
In our view, we will slowly see the USD/CAD exchange back to normalcy as the macro backdrop becomes less volatile. By that we mean, for example, to say that the tight correlation between US stocks and the Canadian dollar exchange rate will decline. There will be more focus on domestic economic data points and the Bank of Canada’s policy actions. The Canadian dollar will become more correlated to traditional metrics like the price of oil and trade flows and yield differentials between the US and Canada.
We believe that the primary driver of the exchange rate in the near future will be the relative strength of the economic recovery in Canada versus that in the US. It will be a simple formula; the better Canada does economically, the higher the Loonie will go. This is because, the recovery will drive Fed and Bank of Canada action and the relative speed with which each moves towards normalcy will be a driving factor in the exchange rates. Canada is in a strong position to outperform but certainly that is not guaranteed. Our relatively strong fiscal position will allow a quicker reversion to normalcy. Our immigration policy can be calibrated to drive growth better than other countries. Our relative economic diversity will allow us to adapt well to new economic patters. The risks to the Loonie will be largely global macro risks such as geopolitical tensions between the US and China, declining energy prices, economic protectionism (especially in the US) and so on.