In spite of a strong economy and rising interest rates, the loonie has been trading at a discount relative to is fundamental value largely due concerns about trade, according to a report published Thursday from Toronto-Dominion Bank.
“The Canadian dollar has been stuck between two conflicting themes. On one side, the economy has been running ahead of expectations, unemployment is below its natural rate, and inflation has increased to the central bank’s target. With this backdrop, the Bank of Canada has kept-up with the Fed in hiking its policy rate 100 bps in a year, providing support to the loonie’s nominal value,” the report states.
“But, on the other side, Canada has a huge amount to lose when it comes to the U.S. Administration’s trade policies,” the report adds, and concerns about trade are the “dominant factor” that has the loonie trading at a discount to its equilibrium value of US80¢ to US82¢.
While the bank’s base forecast is for the dollar to climb back to the US78¢ level by the end of the year, a NAFTA deal could send it notably higher, at least in the short term.
“If a deal is indeed struck, we would expect significant appreciation in the loonie and even a potential overshoot from the 80-82 U.S. cent equilibrium rate,” the report states.
“If not, the trade discount would certainly increase and the loonie could retest the 75 U.S. cent level.”
Energy prices are weakening as a driver for the value of the Canadian dollar, according to the report, as the Canadian economy becomes less commodity dependent.
“As this trend is not expected to reverse, it means that even greater focus will have to be given to central bank rate decisions and relative yield differentials,” the report states.