With U.S. growth revised upward due to government spending and tax cuts, markets have priced in three Fed rate hikes for 2018. That’s allowed the U.S. dollar to put up a fight against global currencies despite a deficit projected to surpass US$1 trillion in 2019.
“Generous long-end spreads versus still-low overseas yields are providing enough of a siren call to offset what remains a sticky current account deficit,” say CIBC economists in a monthly foreign exchange report.
However, the dollar’s fight likely won’t last long.
In a monthly foreign exchange report, National Bank economists say, “By pushing up Treasury yields near 3%, markets are firing a warning shot about their limited tolerance for fiscal indiscipline. The U.S. dollar is unlikely to flourish in such an environment, even with Fed rate hikes in the cards.”
And Trump’s trade tariffs won’t put much dent in the U.S. trade gap. That’s because the tariffs are “narrowly focused, and any improvement in the balance on metals could be offset by the reduced competitiveness of made-in-America products using them as inputs,” says CIBC.
Further, “external developments are likely to dominate” to push the currency down, it says. For example, markets aren’t pricing in the shortened timeline for the end of quantitative easing in the Eurozone and Japan.
Into 2019, the dollar’s decline could accelerate.
At that time, “investors could be looking past the bulk of U.S. monetary tightening, and a potential fiscal tightening in 2020 as a post-election Congress faces the reality of a budget deficit in excess of $1 trillion,” says CIBC.
Losses for the loonie
For its part, the loonie has the ignominious distinction of being the only reserve currency losing ground against the U.S. dollar this year.
Since the end of January, the loonie has depreciated 5%, because of trade uncertainties and softer economic data—and the Canuck buck could have further to fall.
For example, though Canada is excepted from U.S. steel and aluminum tariffs, trade threats have made the markets more aware of protectionist risks.
“NAFTA uncertainties are unlikely to be resolved this year, with the Mexican general elections and the U.S. mid-terms causing negotiators to hit the pause button in the next few months,” says CIBC.
Relative to the Fed, CIBC expects one further quarter-point rate hike by the Bank of Canada this year and two in 2019. “That would lean toward a bit more C$ weakness,” says the bank.
Add in moderating crude oil prices, and pessimism for the loonie grows. For example, diminished flows through an impaired Keystone pipeline have contributed to a large differential between Western Canada Select and West Texas crude, says National Bank.
CIBC forecasts USDCAD at 1.32 by mid-year, “with a general trend toward U.S. weakness against other majors, keeping the Canadian dollar range-bound thereafter.”
National Bank is more optimistic for the loonie, with USDCAD at 1.23 mid-year. That’s because, despite various concerns including NAFTA, “the Canadian dollar has room to appreciate amidst USD weakness, which is likely to be reinforced by a sharply deteriorating U.S. budget deficit.”
Further, global synchronized growth bodes well for commodity prices.
“We have adjusted our targets to show a more resilient loonie over the forecast horizon, albeit with USDCAD remaining in the 1.20-1.30 range for the next 12 months,” says National Bank, adding that those projections assume a favourable outcome for NAFTA.
Euro to benefit
Other major currencies stand to benefit from U.S. dollar weakness. And improved GDP forecasted for the U.S., thanks to fiscal stimulus, has spillover effects for U.S. trade partners.
“IMF research shows that [an] exporting economy’s output would rise about 0.1% on average in response to a 1% GDP overall fiscal shock in the U.S.,” says National Bank.
The eurozone, in particular, will benefit from such spillover effects, because the region has economic slack, which “helps keep inflation under wraps and prevents significant interest rate hikes that would crowd out private investment in the exporting economy,” says National Bank.
The bank has accordingly raised its EURUSD targets. “But the path of the common currency over the coming months won’t be linear, with events such as Italy’s March elections expected to periodically fuel volatility.”