Monthly Economic Letter
Does the Canadian dollar rally have room to run?
Fallout from the onset of the COVID-19 pandemic took the Canadian dollar below US$0.70 in March 2020, but the loonie has recovered strongly to US$0.83, up 20% from last year's low.
The Bank of Canada explicitly identified a higher dollar as an adverse risk to its base case in the January Monetary Policy Report. This was the first time since July 2011 that the central bank has made such a statement. Back then, our dollar was at parity with the U.S. dollar and oil prices were above US$100 per barrel.
While a strong dollar is good for importers and international travellers, it’s a negative for Canadian exporters to the U.S., destination for over 75% of Canadian exports.
The exchange rate between the Canadian dollar and any floating foreign currency is determined by the forces of supply and demand. The foreign exchange market is like any other asset market—expectations about the future are important. And like other asset markets, including the stock market, foreign exchange movements are notoriously difficult to predict.
However, there are some indicators that have historically been useful in trying to forecast currency fluctuations. For the Canadian dollar, the key indicators have traditionally been commodity prices, short-term interest rates and market volatility.
High commodity prices favour the loonie
Natural resource industries represent about 10% of Canada's economic output, while accounting for about 50% of exports. The Canadian stock market also remains heavily commodity-based. As a result, fluctuations in demand for commodities, including oil, account for much of the volatility in the Canada/U.S. exchange rate.
Commodity prices soared as the global economy recovered from the COVID-19 pandemic, and we expect them to continue to do so in 2021 for various reasons.
Demand for metals and minerals has been largely driven by the rapid Chinese recovery while lumber and other wood products have benefitted from booming spending on new home construction and residential renovations. Meanwhile, oil prices appear to have stabilized but may move higher as economies around the world reopen despite increased crude supply expected in the coming months.
Overall, commodity prices should continue to support a stronger Canadian dollar in 2021. However, the recent surge is likely to fade towards the end of 2021 or early 2022, according to our forecasts. This will reflect an easing of pent-up demand for commodities and more supply coming online.
The interest rate differential
A differential in short-term interest rates between Canada and the U.S. was essentially neutralized as a driver of exchange rate volatility at the start of the pandemic. Both the U.S. Federal Reserve and the Bank of Canada lowered their policy rates and both used massive asset purchases to further support low interest rates.
The market is watching closely for signs of coming changes in monetary policy in both countries. The Bank of Canada tends to be more flexible on the timing of rate tightening than its U.S. counterpart. In fact, the Bank of Canada began slowing its bond-buying program in late April and has moved up the possibility of a future rate increase to late 2022 (rather than 2023), while the Fed is maintaining the status quo despite inflation concerns.
Overall, the spread between Canadian and U.S. short-term interest rates could widen, which should help the Canadian dollar appreciate further against the U.S. dollar.
Uncertainty, risk and the stock market
Market volatility reflects changes in risk appetite, global uncertainty and inflation expectations. The VIX, the index representing market volatility—commonly referred to as the fear index—peaked at 82.7 at the beginning of the pandemic. While the stock market quickly recovered its losses from a pandemic-related crash last year, it took several months for the VIX to return to a more normal level.
When market volatility accelerates, investors take refuge in the U.S. dollar as a safe haven. Thus, market volatility usually has a negative impact on the Canadian dollar’s value versus the greenback, not because the loonie depreciates, but because the U.S. dollar appreciates against other currencies.
While exchange rates are notoriously difficult to predict, we believe the loonie will continue to appreciate against the greenback through the summer but not rise above US$0.84 (for long). We then expect it to begin declining early in the fourth quarter to stabilize around $0.80 by early 2022.
Risk or opportunity for entrepreneurs?
- Exporters may find the rising Canadian dollar challenging, but shortages of commodities and some intermediate goods, and the reopening of economies, still bode well.
- If you have investment projects that require imports of technology or other goods and services from abroad, you will benefit from the favourable exchange rate. But hurry, as the loonie is expected to fall back in the first half of 2022.
- Whether your company is an exporter or importer, the important thing is to take the exchange rate into account in your planning to optimize your operations and your return on investment.
Canadian economy at a glance
The recovery stalls at the beginning of the second quarter
While most of the country was locked down during first quarter of 2021, the Canadian economy held up well to the second wave of COVID-19. GDP grew at an annualized rate of 5.6% from the previous quarter. Easing of restrictions in March led to growth in 18 of the 20 economic sectors during that month.
A less rosy picture
The start of the second quarter brought less encouraging news. Preliminary estimates indicate that economic activity in April declined by 0.8%, erasing much of March's gains (+1.1%). This would mark the first decline in 12 months. May is expected to be quite slow as well, as COVID restrictions continued across the country.
In fact, it will likely only be in June that we see any real gains in Canadian economic activity as several provinces move ahead with easing of lockdown measures in the coming days (if they haven’t already done so).
The housing sector takes a breather
Canada's economic recovery has so far been largely driven by a buoyant housing market. While the level of activity is still high, there were some signs of a lull in April.
Real estate resale activity declined between March and April, even though the spring is usually the busiest time for the sector. Inventory levels are low across the country, limiting the number of transactions that can be made. Borrowers became subject to stricter mortgage rules as of June 1.
Housing starts were also down from their March peak. This decline can be explained by health restrictions across the country in April, but also by rising building material prices and supply delays.
Resources are becoming increasingly scarce in construction and renovation because supply has not been able to keep pace with demand. This is the case for commodities such as lumber, but also for factory output where capacity is stretched.
The challenges facing the sector could hamper the recovery in the second and third quarters. The good news is that the Canadian economy is starting to gradually reopen. We should therefore see household spending moving more to services.
Income employment dichotomy
Household disposable income continued to rise in the first three months of 2021. Rising incomes helped push the savings rate from 11.9% to 13.1% in the first quarter. That was well above the trend of the last twenty years. While government transfers are still high from a historical perspective, the increase in income in the first quarter was primarily due to employee compensation.
Income from wages and salaries surpassed the pre-crisis peak at the beginning of the year on a national basis. This was despite a continuing shortfall in employment from the February 2020 level, reflecting the fact that jobs most affected by the health measures are typically lower paying.
Another tough month for the labour market
Unfortunately, but not surprisingly, employment declined again in May. In total, 68,000 jobs were lost in that month, including 52,800 in the sectors most affected by the health restrictions, such as retail trade and other services. Substantial losses were also recorded in the construction (-15,800) and manufacturing (-35,900) sectors for the first time since April 2020. However, the unemployment rate held steady at 8.2 percent.
The easing of restrictions in June should reverse the employment trend of the last two months. Shortages may even occur in some sectors this summer.
The impact on your business
- The residential housing sector seems to be moderating, not because demand is decreasing, but because supply is tight. Businesses in that sector will continue to experience strong demand.
- Provincial plans are signaling that the majority of the Canadian economy will be reopened by the end of June. Therefore, business for bars, restaurants, hotels and other tourism-related sectors should pick up strongly—be prepared to meet pent-up demand.
- Employment should follow the same trend as the economy and pick up steam this summer. Plan ahead and review your recruitment or retention strategies to ensure you have the workforce you need for the summer season and beyond.
U.S. economy at a glance
Is the U.S. economy losing momentum?
Latest data for U.S. GDP growth in the first quarter of 2021 stands at a robust 6.4%. But can the second quarter going to maintain a brisk pace? Between a slowdown in housing activity, industrial sector shortages and inflation fears, the transition to a reopened economy appears to be increasingly challenging.
Inflation undermines consumer optimism
The Consumer Price Index recorded its largest increase in almost 12 years in April. While much of this inflation can be explained by a base effect and transitory disruptions in supply chains, it is spooking consumers, and this could well slow the recovery.
Indeed, consumer confidence is stagnant with the Conference Board and University of Michigan surveys showing a sharp rise in household inflation expectations. The share of households that consider it a good time to buy expensive items, such as a house or a car, has fallen.
Both indices experienced modest corrections in May, and the level of optimism reported in the surveys remains far below pre-crisis levels.
Inflation fears and pandemic uncertainty seem to continue to outweigh good news from the reopening of the economy.
Households have the capacity to spend
Household spending decreased by just under 0.1% in April compared to March. The slowdown in consumer spending was widely anticipated, especially given large fiscal transfers in March. The slowdown affected consumption of goods, while the services sector continues to recover as the U.S. economy reopens.
U.S. real household disposable income was down 15.1% from March because of the lower government transfers. The savings-to-disposable income ratio declined despite this decrease and remains well above the historical average of recent years. All in all, the financial situation of households remains in good shape and should support growth in the second quarter.
Employment still disappoints but labour market tightens
As the U.S. economy moves closer to normal each day, employment numbers continue to disappoint. In total, 559,000 were recovered in May. Unemployment rate stood at 5.8% and 7.6 million jobs are still missing from February 2020.
There are signs employers are having trouble recruiting workers, and this may explain weak employment gains in the past two months despite reopenings across the country. Average hours worked increased in several sectors, which suggests businesses are resorting to overtime to meet demand. More alarming is the growing share of companies that are unable to fill positions, and a spike in new job openings.
Shortages hit manufacturing
In April, the shortage of semiconductors slowed motor vehicle production (-4.3% compared to March). This was reflected in lower vehicle sales. The good news is that semiconductor imports and domestic production have been at record levels recently, suggesting an improvement in supply.
But manufacturers outside the automotive sector are not out of the woods yet. Producers are reporting shortages of raw materials and other intermediate goods in addition to the labour problems. Manufacturing production is already struggling to meet pent-up demand, and the reopening of the economy could exacerbate the problem.
The impact on your business
- Households are still in an enviable financial position and are likely to spend during the summer months.
- However, inflation fears may undermine spending on durable goods in favor of consumption of services.
- The U.S. industrial sector is facing shortages of materials and workers. U.S. companies may have difficulty meeting demand in the coming months.
Oil market update
Three factors to watch for in the oil market
Crude oil prices remained fairly stable in May. Brent crude held steady around US$68 per barrel while West Texas Intermediate hovered around US$65. Oil resumed its upward trend at the beginning of May, but a few factors clouded the picture as the month wore on. The main benchmarks, Brent and WTI, lost more than 6% the third week of that month.
Three elements explain that sudden drop in prices. During the same week, the U.S. Energy Information Agency reported an increase in the U.S. crude inventory of about 1.3 million barrels; the COVID-19 crisis gained ground in Asia (beyond just India); and progress was made on a nuclear deal between the U.S. and Iran.
The latter news sent shockwaves through the oil markets. While they quickly recovered, this temporary disruption shows that uncertainty still reigns in the market.
The following three elements should influence the trend in oil prices in the coming weeks.
The global demand shock experienced by the oil market in 2020 due to the COVID-19 pandemic inflated inventories. While stocks began to decline in September 2020, they only returned to more normal levels this spring. Significant production restrictions imposed by the Organization of the Petroleum Exporting Countries and their allies (OPEC+) supported this rebalancing.
More recently, in May, the oil market appeared slightly oversupplied. According to the International Energy Agency, inventory drawdowns are expected to resume in June, although there is much uncertainty about both future demand and supply. A drop in inventories indicates the oil market is tightening and usually underpins an appreciation in the price of crude.
2. The evolution of the pandemic
While the situation is improving in Canada, the U.S. and Europe, elsewhere the pandemic continues to rage. The evolution of the pandemic worldwide influences fluctuations of supply, but especially of demand.
Many countries in south Asia are now in a bad COVID situatin and forced to impose restrictions on population movements and economic activity. A major concern is the slow pace at which vaccination campaigns are being rolled out in developing countries. Although vaccination began in January, the proportion of people vaccinated is still too low to make a real difference.
New cases threaten the recovery of global economic activity and could therefore slow the recovery of global oil demand, despite the reopening of major economies in Europe and North America.
3. The possibility of a U.S.-Iran nuclear agreement
In May 2018, the Trump administration announced the withdrawal of the United States from the Iran nuclear deal. As a result, U.S. sanctions on Iran were reinstated in November 2018 and extended in 2019 and 2020 to cover Iran's financial sector.
Discussions of a nuclear deal between the two nations are currently taking place in Vienna. Should an agreement come to fruition, global oil supply could increase rapidly. It is estimated there are currently 69 million barrels ready to be shipped should U.S. sanctions on Iranian oil be lifted.
Of course, the success of negotiations and the lifting of sanctions does not mean this oil will reach market overnight. However, the market was already struggling to clear inventories in May as OPEC+ resumed production increases.
Crude oil prices are expected to remain fairly stable in the coming weeks.
Oil demand is once again facing headwinds as economic activity slows in south Asia. However, the situation is very different in Canada, the U.S. and several European countries where health measures are being relaxed just in time for the start of the vacation season. Demand could, therefore, increase faster than currently anticipated.
In response, more supply can be brought to market quickly. Inventories rose slightly in May and OPEC+ still has access to a reservoir of about 7 million barrels per day. And that doesn’t count Iranian oil, which is still under embargo, but which could return to the market if there’s an agreement with the United States.
Other economic indicators
Policy rate remains at 0.25%
The Bank of Canada announced on Wednesday, June 9, that it was keeping its key interest rate at 0.25 per cent. In the April Monetary Policy Report, the bank noted that interest rates could rise sooner than originally expected. April's inflation above the inflation target range is not enough reason to raise rates anytime soon.
The loonie continues to rise
The Canadian dollar has gained a lot of value in 2021 so far. It even surpassed US$0.83 recently, a six-year high. The loonie's growth is mainly due to rising commodity prices, including oil. The direction of the Canadian monetary policy vis-à-vis the U.S. Federal Reserve has also been supporting the rise of the CAD for some time. For more details, see this month's main article.
Business confidence stalls
Not surprisingly, the business confidance remained stable in May according to the Canadian Federation of Independent Business (CFIB). Many of the health restrictions that were in place in April carried over into May across the country. With the majority of opening plans announced at the end of the month, the future of businesses most affected by these restrictions was still uncertain at the time of the survey. Optimism is expected to gain ground in June as the economy reopens and the country moves closer to herd immunity. CFIB notes that the index is hovering around the 50 mark in most provinces, indicating that the outlook is broadly balanced.
Inflation above target range
Inflation as measured by the consumer price index (CPI) has exceeded the Bank of Canada's target range (between 1 and 3 per cent). It is important to note that the Bank of Canada monitors a range of indicators to guide its monetary policy, not just the annual change in CPI. Indeed, even the Bank's own analysis of the CPI is based on a wide range of measures derived from it. There is the truncated, median and common CPI which are the preferred measures of core inflation in Canada. CPI inflation reached 3.4% in April, and the core inflation measures are rising. However, these measures are not significantly different from their historical levels.