Canadian dollar ended 2023 on a hot streak but don't expect the momentum to last

Some economists see loonie sinking as low as 69 cents

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The Canadian dollar ended 2023 on something of a hot streak, but will be hard pressed to keep up the momentum in the new year as headwinds gather and fundamentals favour the greenback, currency analysts say.

The loonie clawed its way back above 75.5 US cents in late December after trading close to 72 US cents as recently as late October. The rally completed a seesaw 2023 in which the currency rose and fell within a range of about 72 to 76 US cents.

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If the Bank of Canada starts to cut interest rates sooner than the United States Federal Reserve, as some are predicting, a reversal from the recent highs could be imminent.

“We’re expecting a period of weakness over the first quarter for the Canadian dollar,” said Bipan Rai, head of FX strategy at CIBC Capital Markets. “That is primarily tied to our view that we don’t think the market is pricing the U.S. dollar appropriately.”

Current market sentiment has the Federal Reserve cutting interest rates first as investors bet that the U.S. central bank is on track to hit its inflation targets, following a dovish pivot by Fed chair Jerome Powell last month. But Rai questions that consensus.

“We think the U.S. dollar is set up to be an outperformer in the first quarter and that is primarily tied to the fact that we don’t agree at all with the way the market is reading the Federal Reserve, nor do we agree with how the market is reading the U.S. economy at this point,” Rai said, adding he believes the Fed will in reality be one of the last central banks to start cutting rates next year. “It’s really all about U.S. dollar strength in the first quarter of next year.”

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If Canadian rates start falling sooner than U.S. rates, look for the loonie to be pulled down as investors chase those differentials.

Earl Davis, head of fixed income and money markets at BMO Capital Markets, thinks “there is a fair chance” the loonie will retest the 72 US cents level if the Bank of Canada eases more than the Fed.

“I think it is very plausible,” he said.

Like Rai at CIBC, Davis thinks that despite market sentiment, there is a “risk”  the Fed will start to cut later, which would weaken the Canadian dollar.

Forecasts for the loonie in the first quarter from Canada’s big commercial banks range from 75 US cents at Scotiabank to 69 US cents at National Bank of Canada.

“Looking ahead, we don’t see much support for the CAD given our forecast for a slowing global economy and the potential for more aggressive interest rate cuts in Canada relative to the U.S. due to weaker domestic demand,” said economists Stefane Marion and Kyle Dahms at National Bank.

Bank of Montreal expects the Canadian dollar to trade around 74 US cents, while Royal Bank has a first quarter forecast of 72 US cents.

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Most economists expect the Bank of Canada to start cutting in the second quarter of next year, but some argue there are forces at play that could see the Federal Reserve begin to ease rates, if not sooner, then at a faster pace.

Scotiabank believes the Fed will cut more than the Bank of Canada — 150 basis points versus 100 basis points — despite the superior performance of the U.S. economy, said economists Jean-François Perrault, René Lalonde and Farah Omran.

“The larger cuts in the United States are prompted by a much better productivity performance, which is allowing that economy’s substantial wage gains to be less inflationary than in Canada,” the Scotiabank trio said.

Productivity is the reason the Canadian dollar is in a “structural bear market,” Bay Street economist David Rosenberg wrote recently.

The currency is “bearing the brunt” of Canada’s stagnating productivity, which declined 2.4 per cent year over year compared with a 2.5 per cent gain in the United States.

“It is a matter of pure math that to re-establish a more competitive cost setting in Canada, the loonie is going to have to act as the antidote to this secular downward path in Canadian productivity,” he said.

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That means that unless productivity improves or wage increases start to ease here, the loonie will need to depreciate “to equalize unit labour costs in common currency terms.”

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Looking further into the year, BMO’s Davis expects the currency to retrace the same territory as it did in 2023 as the latest 10-year commodities super-cycle comes to an end.

“I think the range for 2023 holds for 2024,” Davis said. “We are coming to the end of a business cycle where it’s a soft landing, no landing, medium landing … that’s a big factor in determining demand for commodities.”

Next year “is going to be a consolidation year” for the loonie, he said.

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