The Canadian dollar eroded by 7.8 per cent during 2018 with most of this deterioration coming in the fourth quarter. For cattle producers, this isn’t necessarily negative. Recent data shows that year-to-date feeder cattle exports for the week ending Dec. 8, 2018 were 191,863 head, up a whopping 66 per cent over the same period of 2017.
The U.S. calf crop has experienced four years of consecutive increases so that the 2018 output will be similar to 2007. However, this hasn’t curtailed U.S. feedlot demand for Canadian feeder cattle. I thought this would be an opportune time to review the recent Canadian dollar price action and provide an idea for the first quarter of 2019.
The Bank of Canada increased its short-term lending rate to 1.75 per cent in October. The Canadian dollar had a brief surge to 78 U.S. cents but ended 2018 around 73.5 cents. Until October, the Bank of Canada and the U.S. Federal Reserve were increasing rates at a similar pace. Since October, the Bank of Canada has turned from hawkish to neutral. Investors don’t expect a rate increase in the first quarter of 2019.
While the Bank of Canada was changing its sentiment, the U.S. Federal Reserve increased the interest rate at the Dec. 21 meeting by 25 basis points to 2.25 per cent to 2.5 per cent. According to the fed fund futures, it now looks like investors are not anticipating an additional interest rate hike from the U.S. Federal Reserve in the first quarter of 2019. During the final quarter of 2018, we saw a widening of the interest rate gap between the Bank of Canada and the U.S. Federal Reserve, which was negative for the Canadian dollar.
Inflation concerns evaporate
There are a couple of main reasons for the change in tone from the Bank of Canada. First, inflation concerns have evaporated. Canadian inflationary data for November showed a month-over-month decrease of 0.4 per cent, which reversed the October monthly gain from September of 0.3 per cent. The annualized inflation rate for November came in at 1.7 per cent, which is below the Bank of Canada’s target range of two to three per cent. December and January inflationary data will also be rather soft given current energy prices. Secondly, Canadian fourth-quarter GDP will likely finish around one per cent, down from the annualized growth rate of two per cent in the third quarter and 2.9 per cent in the second quarter. Given the lower inflationary data and softer GDP, the Bank of Canada would have had no reason to increase interest rates at its Jan. 9 meeting.
Speaking of bond yields, there is an important characteristic developing. In late December, the U.S. government two-year bond yield was 2.660 while the five-year bond yield was 2.649. This is the first time the yield curve has been inverted since September of 2007, just prior to the recession. Almost every time the yield curve has become inverted, a recession has followed. Central banks are closely watching this U.S. yield curve as well, which could hinder further rate increases.
From October through December, the Canadian dollar was highly correlated with the crude oil market. In addition to the weaker crude oil futures, the spread between Western Canada Select and West Texas Intermediate was historically wide, adding to the bearish sentiment to the Canadian dollar.
In early December, the Alberta government announced mandatory production cuts of 8.7 per cent which came into effect on Jan. 1, 2019. This caused the spread to narrow to about $13, which is the lowest discount in over a year. These production cuts are expected to curb growth in the oil sector and stem Canadian economic growth but I’m viewing this as slightly supportive for the Canadian dollar.
Canadian fiscal policy is negative for the Canadian dollar. The federal government’s deficit is expected to come in near $20 billion and there is no plan for a balanced budget in the foreseeable future. Very simply — deficits are future taxes.
During the first quarter, I’m looking for the Canadian dollar to trade in a range with support at 72.50 U.S. cents and resistance at 75 U.S. cents. The market is in a situation where it has to absorb the interest rate gap between the U.S. and Canada. At the same time, North America is heading into a period of slower growth. This could amplify the consequences of the Canadian deficit because government revenues could be lower than expected. The neutral monetary policy and negative fiscal policy will keep the Canadian dollar rangebound at the lower levels.