Monthly Economic Letter
What's going on with the Canadian dollar?
The Canadian dollar has been in free fall recently, dropping to around US$0.73. The last time the Canadian dollar was this weak was two and a half years ago at the start of the pandemic. A low Canadian dollar relative to the U.S. dollar favours exports at the expense of imports, which could be good news in the current economic climate.
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, like any other market, reflects expectations about future developments. And like other markets, such as the stock market, it’s highly volatile and notoriously difficult to predict.
However, certain indicators such as commodity prices, the difference between Canadian and U.S. short-term interest rates and the level of stock market volatility can give us an idea of where the loonie’s value is headed in the weeks ahead.
Resource industries account for about 10% of Canada's economy, but about 40% of exports. The Canadian stock market is also heavily weighted with commodity producers. Therefore, fluctuations in global prices for commodities such as oil, metals and grain that trade in U.S. dollars explain some of the volatility in the Canada/U.S. exchange rate.
Commodity prices have dropped in recent months against a backdrop of slowing economic growth. Central banks around the world are raising interest rates to combat surging inflation and this is heightening fears the slowdown could turn into global recession, hurting demand for commodities. The shock to commodity prices caused by the invasion of Ukraine and sanctions imposed on Russia, both major resource exporters, is also fading.
Energy prices (including oil) are down almost 30% from their mid-June highs as fears of weakening demand intensify. Lumber prices, meanwhile, have fallen by half over the past six months as rising interest rates take a toll on the housing and construction markets.
While supply chain issues remain, commodity price corrections are expected to continue in the coming months and keep the Canadian dollar weak against its U.S. counterpart.
The interest rate differential
The short-term interest rate differential between Canada and the U.S. was essentially eliminated by central bank actions during the early stages of the pandemic. To support the economy, the U.S. Federal Reserve and the Bank of Canada both lowered their policy interest rates to the floor and used massive asset purchases to further support low interest rates.
Today, it’s a very different story. Although rates on both sides of the border are moving higher in tandem, the expectations for where they will peak are quite different. The latest Canadian inflation data shows encouraging signs that the worst is likely behind us; this is not the case in the U.S. where core inflation measures picked up in August.
Therefore, the Fed will likely have to raise its policy rate near 5% in 2023 while we expect the Bank of Canada’s policy rate to peak at around 4%.
An increasing spread between short-term rates between the U.S. and Canada favours the U.S. dollar as investors move money to take advantage of the higher rates south of the border. This is another factor that will weigh on the Canadian currency in the coming months.
Uncertainty, risk and the stock market
Market volatility is an indicator of risk appetite, global uncertainty and inflation expectations. The VIX, the index representing stock market volatility—commonly referred to as the fear index—has been high for several months.
The war in Ukraine, the energy crisis in Europe, harsh COVID lockdowns in China and tensions over Taiwan are all contributing to rising uncertainty. Fears of a global recession are also fuelling volatility expectations in the stock market.
In this context, the demand for U.S. dollar as a safe haven currency is increasing. The greenback has appreciated strongly not only against the Canadian dollar, but also against every major currency in the world in recent weeks.
In fact, relative to other currencies, the Canadian dollar has actually done quite well. It’s down 8% versus the U.S. dollar since the beginning of the year, much less than the 15% decline in the Euro and the 20% drop in both the Japanese Yen and the British Pound.
So where is the Canadian dollar heading?
The loonie continues to lose ground as many commodities, including oil, drop in price. Fears of a global recession are gaining momentum and the Fed will likely have to raise rates higher than the Bank of Canada to tame inflation.
All these forces will likely continue to weigh on the Canadian dollar in coming months and favour the U.S. currency. The exchange rate should continue to hover in the US$0.70-0.75 range for some time. A weaker loonie generally favours Canadian exports at the expense of imports. This should temper the economic slowdown in Canada somewhat, but the gains will likely be limited because the U.S. economy is also gearing down.
Interest rate hikes begin to hit the Canadian economy
As we enter the final quarter of the year, the challenges facing the Canadian economy continue to mount. Growth will prove increasingly difficult to achieve as interest rate hikes begin to take a toll on the economy. Still, Canada appears to have held up relatively well in the third quarter. Statistics Canada's preliminary estimate calls for no growth in August. That may seem disappointing but, if confirmed, it would be a commendable performance compared to the struggles of other major economies.
In July, GDP growth surprised on the upside (+0.1% compared to June). Thus, the economy likely produced annualized real GDP growth slightly below 1% in the third quarter.
The financial situation of households is increasingly precarious
Economic growth depends primarily on household consumption. In the current environment, inflation and rising interest rates are reducing consumers’ purchasing power. In fact, the high level of household debt in Canada makes this country's economy more sensitive to rate hikes than, for example, the United States. What’s more, Canadians experienced the largest decline in household wealth on record in the second quarter. It fell by nearly $1 trillion, reflecting significant declines in the stock, bond and real estate markets.
This decline could weigh heavily on consumption because people typically spend less when the value of their assets decreases. This is especially true when consumers are worried about the future and become more wary of making discretionary purchases.
Canadian household debt to disposable income rose to 181.7% in the second quarter, two percentage points higher than in the first quarter. This implies borrowing outpaced income growth in that period. However, large interest rate increases in the third quarter and those expected for the remainder of the year should slow the pace of borrowing.
The economic situation is far from ideal, but at least there was some good news on the inflation front. The Consumer Price Index was down 0.3% in August from the July reading and was even below the June level.
Inflation likely peaked in June, falling from 8.1% to 7.0% in August. The most reassuring part of the August report was the first decline in core inflation measures since the economy reopened from COVID lockdowns, a sign that tight monetary policy is having the desired effect.
While this year’s interest rate hikes (+300 basis points) are finally starting to be reflected in slowing inflation, the Bank of Canada is still expected to hike its policy rate again on October 26.
Unemployment rate declined in September
In other good news, the unemployment rate declined to 5.2% in September as total employment was little changed (+21,000 new jobs).
Despite the employment losses of the last few months, which now total 92,000 since May, the labour market remains tight. In July, the number of job vacancies barely fell below the 1-million mark. Retirements remain elevated in September and students went back to school.
Average earnings continue to soar with a 5.2% annual change, which should temper the negative effects of wealth loss and inflation on consumption.
The impact on your business
- The Canadian economy appears to have grown marginally in the third quarter despite inflation and interest rate hikes. However, the Bank of Canada's rate hikes will constrain economic activity for the remainder of the year. If you operate in a sector where purchases are discretionary or debt-financed, you will feel the impact of the slowdown sooner rather than later.
- The wealth effect generated by the strong performance of the residential and stock markets during the pandemic is quickly fading in the face of the downturn caused by interest rate hikes. This will also moderate consumer demand in the coming months.
- The labour market remains tight in Canada, which is helping to boost wages despite a decline in employment that has been underway for the past few months. This will help moderate the slowdown.
The U.S. economy is flirting with a recession
According to the organization mandated to officially define U.S. business cycles, the U.S. is still not in a recession. While it's not all doom and gloom, the economic outlook on the other side of the border is worrisome and a pronounced slowdown in our largest trading partner would hurt the Canadian economy.
A positive third quarter is crucial
By the general definition—two consecutive quarters of negative gross domestic product (GDP) growth—the United States entered a recession in 2022. However, the U.S. National Bureau of Economic Research, like Canada’s C.D. Howe Institute, defines a recession as a sharp, persistent and widespread decline in economic activity. This is also the definition favoured by BDC economists.
Regardless of the definition you use to describe what’s currently happening in the U.S., third-quarter data will be crucial for the faith of the economy.
Several indicators, including GDP growth, point to an economic slowdown. Yet, the economy added 263,000 more jobs in September, bringing the total for the year so far to 3.8 million. The unemployment rate edged down to 3.5%. Can we talk about a recession without massive job losses?
Faced with still too much inflation and aggressive tightening of U.S. monetary policy, consumers and investors remain pessimistic despite the strength of the labour market. Nevertheless, the most recent estimate from the Atlanta Federal Reserve Bank’s GDPNow model for real GDP growth in the third quarter of 2022 is 2.7%.
Should that estimate be confirmed and inflation moderate, we could see renewed optimism among Americans which would boost consumption, which has been stagnant for several months now.
Manufacturing loses momentum
Manufacturing activity was less buoyant in September but was still growing, according to the ISM index. The index fell two percentage points from August to 50.9%. (An index above 50 indicates the sector is expanding). This is the lowest level since May 2020 at the height of the COVID-19 pandemic.
Employment and new orders contracted according to the ISM report, a clear sign that demand is slowing.
A strong U.S. dollar is a new obstacle
The U.S. dollar strengthened against other major currencies in September, and this could make things more difficult for the economy. A strong dollar hurts industrial production because U.S.-made products become more expensive and less attractive for buyers in other countries.
Conversely, the strong currency should help bring down inflation as the price of imported goods slowdown.
U.S. inflation remains stubbornly high
Inflation was 8.3% in August. In contrast to Canada, the consumer price index remained high despite a significant drop in gasoline prices. Core inflation, which excludes volatile food and energy prices, rose 0.6 percentage point in August. This was larger than the July increase.
The U.S. Federal Reserve's fight against inflation may prove to be more difficult than that of the Bank of Canada. U.S. households have less debt than their Canadian counterparts and the country's mortgage structure is such that 90% of mortgages are fixed for 30 years.
The Federal Reserve raised its key interest rate by 75 basis points in September, bringing it to parity with the Bank of Canada's rate. However, the U.S. rate is likely to peak above the Canadian one in the current environment.
The impact on your business
- The United States is flirting with a recession. A more pronounced slowdown south of the border could accelerate the expected economic downturn in Canada. However, estimates for the third quarter of the year remain encouraging so far.
- This bodes well for Canadian exports, which should benefit from the strong U.S. dollar.
- Demand from the U.S. manufacturing sector is slowing, which suggests a slowdown in the Canadian sector as well. Historically, the Canadian manufacturing, wholesale and retail trade industries are most sensitive to U.S. economic developments.
Don't bet too much on the recent price drop
Major crude oil benchmarks have slipped to their lowest levels since the beginning of the year. Brent crude was trading at US$82.50 per barrel and WTI was as low as US$77 per barrel in late September. Crude oil prices have thus fallen by about 35% from their June highs.
Demand is slowing down
The risk of a collapse in demand for oil is growing as economies around the world begin to slow down. Fears that a global recession will hit in 2023 remain the main reason for the drop in crude prices we’ve seen.
China, the world's largest importer of oil, has already seen a decrease in exports to the U.S. where the economy is slowing. China also continues to lockdown cities at the slightest hint of a COVID outbreak and intends to maintain its strict zero-COVID policy for some time to come.
The strength of the U.S. dollar is further slowing demand for crude by making it more expensive for buyers using other currencies.
Supply/demand imbalance pushes prices down
According to estimates by the U.S. Energy Information Administration, crude oil supply has exceeded demand since July and could remain so until the end of the year. This explains the slide in prices.
But the oversupply is not expected to last much longer. A lack of investment, low levels of spare production capacity and declining inventories point to an oil market in deficit in the coming months, despite slowing demand.
Global oil supply remains tight
OPEC (Organization of the Petroleum Exporting Countries) and its allies, including Russia, reacted to the drop in crude oil prices last month by announcing production cuts of around 100,000 barrels per day in October. Now, at its October 5 meeting, the cartel agreed to a further cut in production by two million barrels per day starting next month to solidify prices.
This is the group's largest cut since 2020. At the start of the pandemic, OPEC+ had cut production by 10 million barrels per day. The latest reduction announced is still 20% of this extraordinary measure, while a global recession remains a risk, not a certainty, at this point.
OPEC+’s production cuts will keep upward pressure on crude prices. The decision was taken in defiance of the wishes of the U.S. Administration, which has been urging Saudi Arabia to increase production for over a year to help ease prices. The U.S. has been dipping into its strategic reserve for nearly 12 months (even before its embargo on Russian oil) in an attempt to curb price increases and calm inflation.
Fears of recession are rising around the world, which is pushing the U.S. dollar higher and making oil even more expensive than usual for crude importers.
As a result, energy demand is expected to slow, increasing the potential for lower prices. However, production cuts by OPEC+ and the risk of further supply disruptions will keep prices high over the next 12 months. The high level of uncertainty is making investors reluctant to invest, inventories are falling, and OPEC+ seem intent on keeping a barrel around US$90 by cutting crude production even further.
Another rate hike expected in October
The Bank of Canada's efforts are starting to pay off. The economic slowdown seems to have begun in Canada and inflation is slowing. It is also true for the core inflation measures which are favoured by the central bank. However, the overall price increase is still too high and there are some international factors that could put renewed upward pressure on prices such as the strong U.S. dollar and tightening oil supply. The scenario that the Bank of Canada will make another rate increase on October 26 still seems the most likely in this context.
The Canadian dollar still falling
The correction in commodity market prices and uncertainty weighed on the exchange rate. The Canadian dollar traded as low as US$0.73 at the end of September.
For more details on the movements of the Canadian currency, see the main article in this month's Economic Letter.
Business confidence hold steady
In the face of growing uncertainty, the level of business confidence was little changed and remains low. In September, the Canadian Federation of Independent Business (CFIB) Business Barometer's long-term index was still above the 50 mark, but only slightly at 52.4.
An index above 50 implies that a majority of companies are optimistic about the future than the opposite.