Will USD/CAD Reject 1.06 Again?

Many of the major currencies such as the euro, British pound and Japanese Yen spent the week trading in their pre-existing ranges but as this was happening the Canadian experienced big moves. The loonie sold off aggressively this week hitting a one-month low against the dollar after breaking through 1.05 a significant resistance level in USD/CAD. Part of the reason why CAD performed so poorly is because oil is off its highs and the U.S. dollar gained upside traction on Fed tapering talk. However the real reason is domestic and that can be a major problem for the currency.

What Inflation?
Since the beginning of the month, we have seen a dramatic deterioration in Canadian data but it took a while for USD/CAD to gain traction. When it did, the move saw significant momentum with the currency pair rallying for six consecutive trading days. According to this morning's consumer price report, inflationary pressures in Canada are basically nonexistent. Overall prices rose 0.1% in July but core price growth was flat. This inability to increase prices is consistent with other reports that showed the Canadian economy taking a serious hit last month. As an export dependent nation, Canada has been running a trade deficit since December 2011 and the outlook hasn't brightened. Manufacturers in Canada cut spending for the first time this year according to the IVEY PMI report. At the same time, wage growth has been the slowest since 2011 and job losses last month were significant. A slower recovery in the U.S. is part of the problem but Canada also had to contend with weaker output by the nation's oil and gas producers, flooding in Alberta and a construction strike in Quebec that affected manufacturing activity and consumer consumption. As a result, the economy is expected to shrink this month, which would be consistent with the Bank of Canada's forecast for an expansion of only 1% in Q2 down from 2.5% in Q1. GDP numbers are scheduled for release next week.

For USD/CAD, the question now is whether the deterioration in data will affect the Bank of Canada's position and strategy. There is no monetary policy meeting in August but when the central bank last met in mid July, they appeared to be in no rush to raise rates. Under Mark Carney, the BoC had been saying that a "modest withdrawal will likely be required, consistent with achieving the 2 percent inflation target" but Stephen Poloz who led his first meeting in July adjusted the language to say that "over time, as the normalization of these conditions unfold, a gradual normalization of policy interest rates can also be expected, consistent with achieving the 2% inflation target." The conditions he refers to include the amount of slack in the economy, the inflation outlook and household sector financials. This left the bias of the central bank slightly less hawkish, a position they are comfortable with at this time. Much of the factors weighing on the Canadian economy in July are temporary (floods, strikes) but depending on how Fed tapering impacts the U.S. economy, the BoC could consider a more dovish stance.

Testing Highs
The following monthly chart of USD/CAD highlights its recent strength and the currency pair now poised for a test of its year-to-date high of 1.0610. The 1.06 level is extremely important because the USD/CAD has tested and rejected this level on numerous occasions. The last time USD/CAD closed above 1.06 was in 2010 and even then it struggled to extend its move beyond this level. The last time USD/CAD saw a significant rally through the 1.06 level was in 2008, during the financial crisis. 2013 very different from 2008 so we believe USD/CAD could fail at the 1.06 level again. However if it does break 1.06 and manages to extend through 1.07, then 1.10 could be the next stop for the pair.

Kathy Lien, Managing Director of FX Strategy for BK Asset Management.