Will energy buffer Canadian dollar from US slowdown?

Energy exports have been a key contributor to Canada's overall trade position in recent years, essentially compensating for the continued weakness in manufacturing exports.

Net energy exports, as a percentage of total net exports, rose from roughly 30% in early 2002 when oil was near US$25 per barrel, to above 100% in 2006 when oil traded above US$70 per barrel. However, the percentage has declined in recent months, from 102% in October to 68% last January.

Oil prices remain something of a wild card for the Canadian dollar (CAD) on several fronts. From a shorter term perspective, the price of oil has started to reverse the steep decline it experienced recently.

If sustained or extended, that should provide more support to the CAD. However, it remains to be seen if the recent rally in crude oil is due mostly to the cold spell in North America, a temporary situation, or whether it stems from a more permanent change in supply/demand dynamics, which if so, will prove to be more long-lasting.

The decline in net energy exports in recent months is consistent with the pullback in the CAD over the same period, just as the rise in energy exports supported the CAD in previous years.

Furthermore, in the short term, it is highly anticipated that the CAD will remain sensitive to energy market developments. This is consistent with what has happened so far this year.

Despite the considerable buffer that high energy prices have provided to the Canadian economy, there is no question that developments in US growth will continue to exert a profound influence on Canada. How profound this influence will be is the main question that needs to be answered.

Taking an example, the surprising 7.8% plunge in US durable goods orders in January bodes ill for Canadian manufacturing shipments. Canadian manufacturing shipments do indeed show sensitivity to developments in the US durables series.

In addition, the recent softness in the US housing sector also bodes ill for Canada's forestry industry and exports, given the hefty portion of that sector's output, which supplies the US building industry.

The downgrading of US economic expectations has resulted in a significant decline in US market interest rates, with Canadian rates following suit, although to a lesser extent. Hence, there has been some narrowing in US-Canadian interest rate differentials (that is a reduction in the US interest rate premium) that was also consistent with US$-CAD's decline last month.

In US$-CAD's case, the recent narrowing of US-Canadian spreads - roughly 25 basis points at the short end of the curve and 15 basis points in the 10-year sector - has not given the CAD much sustained support.

That may be because the recent uncertainty and downgrading of the US outlook creates similar uncertainties and doubts about Canada's economic prospects. Although globalisation and the increased economic importance of economies in Asia and Europe may have reduced the potential impact of a US slowdown on global growth, there is little doubt that Canada, which still sends over 80% of its exports to the US, would be spared the effects of a weaker US economy.

As a result, a decline in US yields and US-Canadian interest rate differentials associated with perceived risks to the US economy is not the type of development that should be expected to support the CAD. If anything, one could argue that the opposite is more likely.

Looking ahead, US and Canadian economic performance, as well as financial market developments, will be the critical elements for the CAD. Given the expectations for a less upbeat outlook for US growth in the coming months, the risk is that those same sentiments may spill over into Canada and weigh on the CAD as well in the short term.

However, it will not be a one-way bet. This month there have already been a series of strong Canadian indicators. Not surprisingly, those reports have been accompanied by a modest pullback in US$-CAD.

However, if the assessment of the US economy is correct (that is, that it will weaken), such strong Canadian data will hardly be the rule, and weakness "south of the border" will create headwinds for Canada's economy and the CAD, keeping US$-CAD biased higher in the coming months.

However, if CAD were to break the shackles of the US because of the commodity link, then a profound rally in the CAD is to be expected. Interesting times are definitely ahead!

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.