Our central bank may soon have reason to welcome a higher dollar

Good Morning!

The Bank of Canada has made it clear it’s worried about Canada’s high-flying currency, but what if it soon had a reason to welcome it?

Capital Economics says its above-consensus forecast last year that the Canadian dollar would hit 83 US cents in the third quarter raised eyebrows at the time. But even it fell short of the mark, with the loonie hitting 83 this month. (It was trading at 82.79 this morning).

The higher currency prompted a warning from Bank of Canada Governor Tiff Macklem.

“If it moves a lot further that could have a material impact on our outlook and it’s something we’d have to take into account in our setting of monetary policy,” Macklem said earlier this month.

“If the dollar were to continue to move — particularly if it’s not reflecting good developments for Canada — that could become more of a headwind on our export projection.”

Improving fundamentals are behind much of the currency’s rise, says Capital. Commodity prices have been red hot and a brighter economic outlook has the Bank eyeing stimulus withdrawal ahead of most other central banks.

Indeed, New Zealand’s currency jumped 1.1% this morning after its central bank hinted at a possible rate hike by September next year. 

“There are now several central banks that appear to be closer to a tightening cycle than the Federal Reserve, and markets are sensing that,” Imre Speizer, Westpac’s head of New Zealand strategy, told Reuters, identifying the currencies of New Zealand, Canada and Norway as driven by aggressive central bank expectations.

Some of it, however, is not rooted in the domestic and may reflect the weakness of the U.S. dollar, another cause for concern.  

But while a stronger currency is not normally welcome because it can be a drag on trade, Capital’s senior Canadian economist Stephen Brown argues that a high loonie may soon prove useful. 

The reason: the post-pandemic spectre of inflation. The 3.4% spike in April came in hotter than the Bank was expecting based on its forecasts. With inflation rising even before the economy has opened, Capital believes it will average 0.5 percentage points higher for the rest of the year than the Bank expects. 

“In this environment, the strong loonie will act as a pressure valve by lowering imported goods prices,” said Brown. 

The economist said that the reaction of goods prices to the exchange rate may be delayed because of supply disruptions. And this explains why, even though Capital expects inflation to be stronger this year, it agrees with the Bank’s forecast that it will drop back to less than 2% in 2022.

The timing of this is key, says Capital, because that is exactly when markets are expecting the Bank of Canada to raise rates. 

“With the Bank pledging not to hike until it is sure 2% inflation will be sustained, we think it will wait for inflation to rebound before pulling the trigger in early 2023,”  said Brown. 

The impact of a later move by the Bank and a forecast that commodity prices will fall has Capital predicting that the loonie will come back to earth next year. It expects the Canadian dollar to end 2022 at 78 US cents from 82 cents at the end of 2021.