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The dollar

Saturday, March 18, 2017 11:01
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RYAN  By Guest Blogger Ryan Lewenza

What a difference a few months can make. It appears that the Federal Reserve (Fed) and President Trump may finally be on the same page about the US economy and interest rates. Recall that President Trump criticized Fed Chairwoman Janet Yellen during the election campaign for keeping rates low for “political reasons”, and even went so far as to malign government unemployment statistics as “phoney”. My favourite Trump quote on the US unemployment rate is “5.3% unemployment — that is the biggest joke there is in this country. The unemployment rate is probably 20%, but I will tell you, you have some great economists that will tell you it’s at 30, 32. And the highest I’ve heard so far is 42%.”

Well fast forward a few months, and President Trump now residing at 1600 Pennsylvania Avenue, he seems to have changed his tune on the employment statistics, recently taking credit for the large increase in new jobs. This was also echoed by his press secretary Sean Spicer who tweeted: “Great news for American workers: economy added 235,000 new jobs, unemployment rate drops to 4.7% in first report for @POTUS Trump.”

Frankly, I could care less about President Trump’s apparent flip-flop, since after all, that’s what politicians do, but I do care about where US interest rates are headed as this has implications for our dollar and how we position client portfolios.

This week the Fed hiked its benchmark rate by 25 bps to a range of 0.75% to 1%. This marks the third rate hike over the last two years and they are not done yet. With the US unemployment rate at 4.7%, indicating near full employment, and inflation starting to rise, the Fed is fulfilling its mandate of full employment and stable prices so we should see further tightening over the next few years. Given this outlook, we see the potential for short-term weakness in the Canadian dollar over the next quarter or two.

Stepping back, the Canadian dollar is driven by two key factors – oil prices and the interest rate differential between Canadian and US bond yields. Below we illustrate this important relationship between CAD/USD and the differential between Canadian/US bond yields. Note the high correlation of 0.98 between these two variables.

With the Bank of Canada on hold for the foreseeable future and the Fed clearly in tightening mode, US bond yields should rise faster than Canada yields thus resulting in a widening interest rate differential in favour of the US dollar. As such, we see the potential for short-term weakness in CAD, with it possibly declining back down into the low $0.70s.

 Fed Rate Hikes Are Negative for CAD 

Source: Bloomberg, Turner Investments

However, from a longer term perspective we believe any short-term Canadian dollar weakness would be a buying opportunity as we see the potential for the CAD to recover later this year and into 2018. Using a sports analogy, the CAD looks like the New England Patriots in the recent Super Bowl with weakness in the first half followed by strength in the second half of the game.

Oil prices are incredibly important for the CAD which can be seen in the chart below with a very high 0.95 correlation between the CAD and WTI oil prices. This is why the CAD is referred to as a “petrodollar”.

I’m calling for oil prices to strengthen this year, more likely in the back half of the year, as demand hits new record highs and we see more a balanced global oil market. We see the potential for WTI to rise to US$60/bbl by the end of this year. If this plays out, then we could see a higher CAD later this year and into 2018.

 Higher Oil Prices Are Positive For CAD 

Source: Bloomberg, Turner Investments

Based on these important drivers we constructed a financial model to help forecast the CAD. Given our expectations for oil prices and Canada/US bond yields, we see the CAD recovering from the lows of $0.70s in the H1/17 to roughly $0.80 in H2/17 and into 2018.

 Our Model Points to H2/17 Recovery for CAD 

Source: Bloomberg, Turner Investments

Ok, so what’s the plan, Stan? We continue to recommend a healthy 20% net USD exposure in portfolios given our outlook for CAD and the fact that the USD acts as an important portfolio diversifier and shock absorber. If the CAD were to drop into the low $0.70s/high $0.60s, we may consider reducing our USD exposure in anticipation of a recovery in CAD later this year and into 2018.

Ryan Lewenza, CFA,CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.


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