Over the latter part of the past year, the Canadian dollar sank about 6 percent against the United States dollar. The declining CAD reflects a shift in monetary policy, as a new central bank head took over with a more dovish outlook, said Camilla Sutton, managing director and chief currency strategist at Scotiabank.
Global demand for commodities, a major force behind CAD strength, also abated and is expected to decline, particularly in light of slowing Chinese growth. In addition, Sutton said, “as U.S. oil production ramps up, there are concerns about demand for Canadian oil.” All this “is negative for the Canadian dollar.”
It’s important to remember that the decline took place toward the end of 2013. “The currency was remarkably stable for most of the year,” said Craig Wright, senior vice president and chief economist at RBC. “The CAD weakness is the ‘flip side’ of the USD strength.”
The view is that the U.S. dollar has reached its low and that some of the earlier, worrisome signs, like U.S. fiscal and current account deficits, are improving. Plus, the American economy is doing better, and the U.S. Federal Reserve is beginning to taper its bond-buying program. Scotiabank and RBC see a weakening CAD through 2014.
RBS’ official forecast puts the CAD at around 1.08 at the end of 2014, from the current level of 1.0660. The reason, according to Nitin Gupta, director of corporate foreign exchange at RBS, is that the Bank of Canada will likely retain a dovish tone throughout 2014. Headline inflation is currently slightly below the lower bound of the bank’s 1 percent to 3 percent target range and expected to normalize only gradually.
At the same time, the expected recovery in export performance and business investment is likely to remain sluggish. While there’s been some talk of the Bank of Canada tightening before the Fed, Gupta doesn’t share that sentiment. He believes the USD will continue to be bolstered by relatively higher interest rates. At the same time, steep yield curves in the U.S. and elsewhere are particularly risky for countries running current account deficits, including Canada.
Jeremy Stretch, executive director and head of foreign currency strategy at CIBC World Markets in London, sees a different outlook, with a weaker CAD continuing for the first quarter of 2014 with the peak being in Q1 up to potentially as high as 1.10 prior to a 12 month reversal back towards 1.04. A stronger North American economy will boost the export-driven Canadian economy as commodity demand rises while overall global growth recuperates.Hedging implications
The increased CAD/USD volatility has contributed to a greater interest in using options. “Companies have traditionally been averse to paying up-front premium,” Sutton said. “But if you put it in terms of paying for insurance it helps shift the mind-set. The cost is very low compared to the potential cost of what you are insuring against.”
As volatility rises, Wright also expects an increase in hedging activity. Many Canadian companies had planned their budget based on parity for year-end and the decline means they have been left exposed. “Although it’s a bit early, I expect companies to review their hedging policies,” he said.
One of the more interesting emerging conversations is around funding, Gupta said. “Canadian corporations may fund their operations in part with CAD debt and may have assets in the U.S. and are long USD, or have revenues referenced to a USD-based index like WTI or Brent,” he said.
Subhed: Earnings boon
Overall, the weaker CAD has been a boon for Canadian companies’ earnings, particularly in the USD-denominated energy business. But the picture is more complex as some companies have revenue and expense sources in multiple currencies or deal with illiquid commodities. Experts expect the growing volatility especially in the next quarter to spark more hedging activity among Canadian companies, particularly ones that have some leeway to take advantage of lower rates.
Although the consensus is that the CAD will end up lower at year-end, some outliers like CIBC have a different view. It’s incumbent on treasurers to take all these views into account, particularly as their funding and cash-flow sources are not matched up.A longer version of this article appears in the January/February edition of AFP Exchange.