What is holding the Canadian dollar back?
After all, the news has been pretty good of late. We’ve had decent data that are causing Q3 GDP estimates to be taken higher. Then there’s the new trade agreement that removes a cloud of uncertainty. All Canada had to give up was one basis point of GDP growth in the form of giving American farmers limited access to Canada’s dairy market, and in return Chapters 19 and 20 of the old NAFTA were preserved — this was our “red line” equivalent. Because Canada’s trade officials balked at the fake deadlines declared by Donald Trump, they pushed the envelope out to Sept. 30, which was do-or-die time for the deal in order to make sure the outgoing Mexican president had time to sign before leaving office (though the U.S. Congress still has to approve what’s in front of them).
With Canada signing on, a removal of uncertainty now allows the Bank of Canada to go ahead with a rate hike later this month.
Also, we just had a Quebec election that brings the number of Canadians under provincial governments that are business-friendly and right of center to 70 per cent from a mere 6 per cent a year ago.
If Alberta’s polls are prescient, on a similar shift in their 2019 election, that 70 per cent share becomes 82 per cent. If only these provinces weren’t completely debt-burdened, maybe they’d have the resources to do something exciting. Still — sentiment from a markets standpoint should improve at the margin.
As we have discussed recently, there remains a large enough net speculative short position left to be squeezed in the futures & options pits, though the bears could come back and say that most of the squeeze has already occurred (with the outstanding short position having plunged 65 per cent since July 10th).
And, of course, there is this matter of the bull market in oil, which has taken WTI up to over US$75 per barrel — a level that would ordinarily be consistent with a Canadian dollar north of 82 cents US or around C$1.22 the “other way.”
But the loonie is nowhere near 82 cents, even after this little rally, which told us that the NAFTA-related uncertainty on its own only mattered to the tune of barely more than a penny! Imagine that — if oil were all that mattered, if the loonie were truly just a petro-currency, it would be more than 4 cents higher than it is today. And all those snowbirds and Buffalo Bills season ticket owners in Toronto, and along the Niagara Belt, would be dancing the Hora in classic bar-mitzvah style.
So what are the factors behind the Canadian dollar’s lingering malaise and inability to act more consistent with where oil is trading?
First, we are uncompetitive on trade. Canada’s current account deficit is massive and amounts to nearly 3 per cent of GDP. Imagine that for all the griping out of the Trump trade team, the U.S. trade and payments imbalance is a full percentage point lower. The last time Canada did not have a current account deficit was back in the third quarter of 2008 — and the Canadian dollar back then was just a shade below par. So we know what has to happen for the loonie to revive on any meaningful and lasting basis — we need to become more competitive. That means export volumes have to do a lot better than merely be at the same level they were at nearly three years ago.
Canada also is very uncompetitive when it comes to top marginal tax rates for both corporate and personal taxes. Sadly, the federal government, feeling obliged to fill its 2015 campaign pledge on tax fairness, has flashed signals that little will be done to redress the tax rate gap in its next budget. This is a critical factor clipping the loonie’s wings now and in the near future.
And no matter what the Bank of Canada does this month, no way, no how, is it going to match the four additional hikes that the Fed is signalling at the current time through to the end of 2019. Canada’s labour market is tight, to be sure, but while the output gap is closed or nearly so, the U.S. economy already is operating in excess-demand terrain — and is exacerbated by the fiscal stimulus boost. Even when you put the six per cent Canadian unemployment rate on the same definitional footing as the U.S., it is still 100 basis points higher — hence the rationale for the BoC to continue to lag the Fed on this rate-hiking cycle.
As a result, the U.S. is a deeper inflation threat and this will be reflected down the road in a widening in Canada-U.S. negative interest rate differentials (already at -50 basis points at the front end of the yield curve). This monetary policy gap is as important, if not more so, as the tax-rate gap. If the BoC could ever manage to close the rate gap, with current oil prices being sustained, the Canadian dollar would surge to nearly 87 cents (U.S.) or C$1.15.
So what is an investor in Canada to do in an environment where the loonie remains a flightless bird? Well, considering that the local stock market trades at a two-point multiple discount to the USA, it does point to some relative valuation support. Second, it pays to keep in mind that the TSX is not the Canadian economy, nor is it inversely correlated with the Canadian dollar. Not a bit. In fact, over half the TSX revenue pool actually comes from business activity outside the country, with Industrials, Financials and Real Estate among the most exposed to foreign-sales — and are the sectors that deserve the most investor focus at the current time.