TD: The Loonie Spreads its wings

TD: The Loonie Spreads its wings

The loonie has spread its wings, rising from 95 U.S. cents at the end of last month, to currently hovering near parity. The Canadian dollar has received support from a string of stronger-than-expected economic indicators increasing the odds that the Bank of Canada will move with the first 25 basis point interest rate hike in July. This contrasts with sentiment coming from the U.S., where interest rates are expected to remain unchanged for the rest of this year.

It’s important to note that while the Fed is not expected to raise interest rates soon, it has already started to rein in some of the monetary easing that was put in place in 2008/2009 to stimulate the economy. For instance, the Federal Reserve has been closing the special liquidity facilities that it created to support markets during the crisis. So, even though interest rates will remain at their current level, implicit tightening is occurring in the U.S., ahead of the Bank of Canada’s expected first interest rate hike.

The Canadian economy warrants a tighter monetary stance, with the economic data pointing to an increasingly solid economic recovery. This week alone, manufacturing shipments, wholesale trade, and retail sales were all stronger-than-expected, and pointed to a robust 0.4% gain for monthly GDP in January. This would put the economy on track for growth close to 4% annualized in the first quarter of 2010. This contrasts to the U.S., where the economic data is suggesting
a deeper moderation in economic growth in the first quarter of 2010 to 2.7%.

More importantly, the data releases in Canada indicated that the amount of slack accumulated over the recession is starting to be eaten up at a quicker pace than originally anticipated, and correspondingly there may be less downward pressure on inflation. In particular, the inventory-to-sales ratios
for the three major sectors noted above (manufacturing, retail sales, and wholesale) have now returned to historical levels, leaving firms with less incentive to provide discounts to attract buyers. Evidence of this is coming from the automotive industry where dealers have ended the deep purchase incentive programs offered to customers over the recession, contributing significantly to a 2.1% rise core inflation in February. Spending in the travel and accommodation sector due to the Olympic games in B.C. accounted for 83% of the monthly gain in the month. However, stripping out this impact, core prices still rose 1.9% year over year –close to the Bank of Canada’s target.

There is some speculation that a rising Canadian dollar would keep the Bank of Canada from raising rates in July due to the loonie’s dampening impact on exports. Indeed, exports have already begun to cool from double digit gains over the second half of 2009 – to more tepid growth in the range of 3.5-4%. However, exports are currently performing below the Bank of Canada’s expectations and are not contributing significantly to the better-than-expected performance
of the economy. The economic surprises have come from a more solid rebound in domestic demand, led by consumer spending. Record low interest rates, improvements in household wealth, and the Canadian labour market suggest that the solid performance of the domestic economy will continue through the first half of 2010, and this could exert some upward pressure on inflation, despite any offsetting weakness that may be coming from trade. Indeed, as the adjacent graph shows, core inflation is already exceeding the trajectory of growth experience during the 9 months following the start of the 1990’s recession. This gives the Bank of Canada good reason to raise rates in July, ahead of the Fed, and despite a high Canadian dollar. It is important to stress that even as the Bank of Canada raises rates from their current emergency low levels, the interest rate environment will still be highly stimulative in Canada, with our forecast of overnight rate at just 1.25% at the end of 2010.

With Canada-U.S. interest rate differentials widening as the year progresses, and with favourable Canadian macroeconomic
fundamentals, it is likely that a strong Canadian dollar is here to stay for the year. The Canadian dollar is expected to hover near parity for the rest of the year.

Diana Petramala, Economist
SOURCE: http://www.td.com/economics/weekly/mar1910.pdf