Currency outlook

Canada's economy has exhibited the anticipated signs of slowing, confirming the Bank of Canada's decision to stop raising interest rates earlier this year. To date, the economic slowdown and the BoC's policy shift have not presented any obvious problems for the Canadian dollar, which has continued to outperform other G7 currencies versus the US dollar over the past month.

During that period, the Canadian dollar rose 1.4% versus the US currency, while the euro, sterling, Swiss franc and Japanese yen all fell against the greenback. There are several factors that account for the strong profile in the Canadian dollar.

As has frequently been the case, energy prices top that list with oil trading above US$77 in early August before retreating more recently. Natural gas prices were somewhat less supportive as they fell steadily, although they remain above support.

The key question revolves around the future path of energy prices. Variables, such as the hurricane season and the approaching winter season in the US, not to mention underlying geopolitical tensions, make such issues difficult to answer.

On the negative side, oil analysts cite the end of the summer driving season in the US and bulging crude oil stockpiles as factors that often depress prices. On balance, with oil prices falling below US$70, there are some downside risks to the Canadian dollar if that trend continues, given the currency's sensitivity to energy market developments.

Cross border mergers and acquisitions (M&A) flows were also quite topical in Canadian dollar trading this past summer. Although the timing, financing and complexity of many of these deals often makes it difficult to tie specific transactions to Canadian dollar-demand on a real time basis, the underlying trend of foreign demand for Canadian companies, most of it commodity-related, is another supportive factor.

Another factor that is still at least somewhat Canadian dollar supportive is Canada's interest rate profile. Although the BoC's last rate hike was in May, and policy is now expected to remain on hold for the foreseeable future, yields in Canada are still above those in most other G7 countries.

Importantly as well, Canada's money market interest yield curve remains positively sloped, meaning markets have not yet begun to price in the risk for interest rate cuts by the Bank of Canada. However, the slope of that curve has narrowed considerably since late June, and one-year Canadian deposit rates are now nearly on top of one-month deposit rates.

In terms of current levels and positions, the Canadian dollar's strong price action in the past month would suggest a higher level of long positions in the market. While the latest data show that speculators hold relatively large long Canadian dollar positions, they are not at the elevated levels that existed earlier in the summer and are well below the record long levels from the turn of the year.

The point is that with the market not overly long, the risk for corrective declines in the currency is perceived to be less severe.

However, these data are only one measure of Canadian dollar positions and do not take into account positions in the spot market versus cross rates. Looking at the Canadian dollar performance against the major currencies since June, some sizable movements versus the yen and sterling, in particular, can be noticed. Speculators have also been active in other currencies.

The point is that Canadian dollar trading on the cross rates has become a more important factor in the currency's overall performance relative to historic patterns, where formerly the US dollar-Canadian dollar exchange rate dominated. Movements in cross rates such as against the yen and euro can and do impact this trading.

On the data front, there were several recent reports that were noteworthy. Both headline and core inflation came in somewhat higher than expected. However, there appears to be no significant change in the BoC's longer term forecast that headline inflation will move back to the 2% target in 2007.

Separately, second quarter GDP rose 2% following a downwardly revised 3.6% gain in the previous quarter, which was weaker than expected. Deterioration in net exports was largely responsible for a more dramatic slowdown in growth.

Along those same lines, the current account surplus narrowed sharply. Strong growth and a healthy external surplus are two key factors that Canadian dollar bulls regularly highlight in their long-term forecasts. However, the latest instalments of those data suggest that there is at least some deterioration in the fundamental backdrop for the Canadian dollar.

In terms of price action, the decline in the US dollar-Canadian dollar exchange rate in recent months has stalled at a certain level. The currency pair has not been able to sustain declines below this level since last May.

In spite of the most recent developments in Canada and in commodity markets, it is doubtful that the US dollar-Canadian dollar exchange rate will make a sustained move below this threshold level in the near term.

This report was compiled by Peter Calleya, manager, Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.