FxWirePro: Loonie likely to gain traction on NAFTA, more USD/CAD retracements likely on policy spread narrowness

Following the early-summer policy-shift and repricing of USDCAD lower, our medium-term projection remains for some modest retracement in USDCAD in the coming quarters.  With downside broad dollar risks lingering longer, the targets are marginally expected, now expecting USDCAD year-end to 1.29 (prior 1.30) and to peak mid-18 at 1.32 (1.34).

Numerous constructive developments have ensured that USDCAD moved away from the 1.28 mark again last week. Positive inflation data created optimism amongst CAD investors on Friday, fueling hopes that inflation might return to the center of the BoC’s target corridor.

The primary driver of USDCAD remains the relative priced pace of policy normalization.  The assumption behind a partial retracement higher in USDCAD is the expectation that relative monetary policy pricing will converge somewhat in the coming quarters.  Post the June/July repricing, BoC is now priced to hike 67bps in two years, compared to the 32bp priced for the Fed, which in other words anticipates the policy rate spread (currently 39bp) to disappear.

Buoyed by the robust labor market advises that the likelihood of a further rate step before year-end priced in by the market is rising. From the point of view of some analysts, CAD also benefits from the “constructive” start of the NAFTA renegotiations.

However, that is exactly what is causing a skepticism that the BoC really will hike interest rates again this year. The USA’s aim is to grant protection against currency manipulation a particularly important position in the renegotiation of the NAFTA agreement. As a result, the BoC cannot easily use verbal instruments at present to slow the appreciation of CAD.

However, the latter is at risk of accelerating if the BoC continues to indicate a relatively aggressive rate hike cycle with rapid rate hikes. As our calculations suggest that the underlying inflation trend remains at the lower end of the target range at just above 1% we doubt that the BoC has much tolerance for a stronger CAD as it will put additional pressure on inflation via low import price.