Where’s the dollar headed? 3 factors will weigh in 2018
The value of the Canadian dollar is one of the most closely watched numbers by entrepreneurs. Naturally, they want to know where the dollar is headed in 2018.
While there are no sure bets in forecasting something as volatile as currency values, we expect the loonie may depreciate marginally this year. It could fall as low as 75 cents against the U.S. dollar from the 78-to-80-cent range of the last six months. We base our analysis on three factors: oil prices, interest rates and the North American Free Trade Agreement (NAFTA) negotiations.
Oil prices have the most impact
Oil and gas industries represent about 10% of Canada’s economy. Energy products, largely oil and gas, currently account for about 14% of our exports, but their share was as high as 24% in 2014. The demand for oil-related products (priced in U.S. dollars) creates demand for the Canadian dollar, and the higher the oil price, the more Canadian dollars are in demand. This phenomenon explains a good portion of the volatility in our exchange rate vis-à-vis the U.S. dollar.
As the chart below shows, the loonie closely tracks movements in oil prices. Since January 2016, when crude hit a low of US$31 a barrel, prices have strengthened considerably, helping to lift the dollar in 2017, although the two uncoupled in the second half of the year.
While oil prices started 2018 at US$60 a barrel, they are likely to fall by a few dollars over the year. Higher prices have dampened demand for oil and stimulated production in the U.S. Taken together, these two developments will mean a surplus of crude in 2018 that will depress prices. Therefore, we expect the support oil gave the Canadian dollar in 2017 to lessen this year.
Interest rates to hit the dollar
Another source of strength for the dollar last year was Canada’s surprisingly strong economic performance, along with two interest rate hikes by the Bank of Canada. Since the summer, we’ve seen stronger growth in the U.S., while Canada’s economic growth has slowed. A new tax plan approved by Congress just before Christmas will further stimulate the U.S. economy and encourage the Federal Reserve to continue with rate hikes in 2018.
Meanwhile, with Canada’s economy slowing, the Bank of Canada may not raise rates again until March or April. As the gaps in economic momentum and rates widen, Canada’s dollar will come under pressure.
NAFTA uncertainty also hurts the loonie
The U.S. is Canada’s most important trading partner, accounting for over 70% of our exports of goods and services. We noted in October that if NAFTA fell apart, trade with our neighbour would continue, most likely under World Trade Organization rules.
Still, the uncertainty will not go away until a deal is done or NAFTA collapses. The longer the negotiations continue, the greater the uncertainty and potential for a negative impact on the Canadian dollar becomes.
The bottom line?
Although many factors may influence the value of the dollar during the year, at this point, we believe the dollar will trade at around 75 cents U.S. during 2018.
What should entrepreneurs do?
- Consider exporting your goods and services. The U.S. remains an important market for Canadians and with a weaker loonie, your products and services will be more attractive to Americans.
- Investigate new markets, such as Europe. The Canadian dollar depreciated against the euro in the second half of last year, making Canadian exports cheaper for Europeans. In addition, Canada’s comprehensive new trade agreement with the European Union came into effect in September 2017. It offers 0% tariff rates on 98% of traded goods and services.
- Examine inputs for your products. If you need to import some inputs, evaluate whether to buy earlier than planned, before a possible depreciation in the Canadian dollar. Both exporters and importers should plan for currency fluctuations.
U.S. economy at a glance
U.S. economy stays strong
The U.S. economy grew at an annualized rate of 3.2% in the third quarter (the mid-point of the two earlier estimates made by the Bureau of Economic Analysis). Household spending, business investment, all levels of government and exports all positively contributed to growth. The only drag on growth was residential investment.
U.S. tax plan considerably reduces taxes for corporations
The U.S. tax plan will reduce the statutory corporate income tax rate from 35% to 21%, effective January 1, 2018. Other important measures for businesses include the ability to expense investments in machinery and equipment (rather than amortize them), a cap on the amount of interest expense that can be deducted (to a maximum of 30% of earnings, versus full expensing) and the adoption of new international tax rules similar to those in other Organisation for Economic Co-operation and Development (OECD) countries. Various economists suggest that the tax plan may lift U.S. GDP growth by about 0.2 percentage points in 2018—that is, GDP growth is now expected to hit 2.7% in 2018. Canadian companies that make a significant portion of their sales in the U.S. will benefit from lower corporate taxes.
U.S. economy continues to create more jobs
The U.S. economy created 148,000 jobs in December and the national unemployment rate remained at an historic low of 4.1%. Over the year, the following sectors created the most jobs (in order of importance): professional services, health care, food services, construction and manufacturing. The retail sector shed a net 67,000 jobs in 2017. Average hourly wages grew by 2.5% in December, the same rate at which they grew throughout the year.
Oil market update—January 2018
Will oil prices continue their rise in 2018? It seems unlikely, as the recent highs do not seem sustainable
Global situation recently driven by stronger demand and shrinking supply
So far, 2018 is looking good for most oil producers: Brent crude oil is trading at about US$66 per barrel and West Texas Intermediate (WTI) is trading at about US$60 per barrel.
The strong rise in global benchmark prices over the past year is due to both supply and demand factors.
Synchronized global economic growth strengthened oil demand last year. In particular, the U.S. economy demanded more oil for manufacturing products and transporting them to customers. This strong domestic demand was partly responsible for the significant drawdown in U.S. oil inventories in December.
Oil supplies have tightened recently, supporting higher prices. The three main factors driving this tightening are the supply cut extension into 2018 by the Organization of the Petroleum Exporting Countries and other major oil-producing nations; a crack discovered in a key Brent crude pipeline in the United Kingdom, putting 450,000 barrels a day offline; and the violent protests in Iran.
These supply and demand factors have combined to keep prices relatively high in recent weeks; however, those high prices are unlikely to continue throughout the year. Higher prices have generated higher production, especially in the U.S., now producing around 9.7 million barrels a day. The International Energy Agency (IEA) forecasts that global supply growth, 75% of which is coming from the U.S., will be stronger than demand growth next year, and this will put downward pressure on prices. The IEA expects the other important countries contributing to supply growth will be Brazil, Kazakhstan and Canada, with Canadian production hitting about 5 million barrels a day in 2018.
Higher prices will dampen demand, according to the IEA. It estimates that a 10% increase in the price of Brent crude oil lowers demand by about 200,000 barrels a day.
Canadian producers not benefitting from global price rise
For most Canadian producers, the global upswing in prices has not provided many benefits. Western Canadian Select (WCS) has taken a major dip and has been trading recently at about US$30 per barrel below the price of WTI. The excess supply of WCS has been partly due to the closure of the Keystone pipeline after an oil spill. Traders may also be putting pressure on the WCS price, given difficulties related to building two important pipelines to get western oil to the global marketplace. TransCanada is trying to negotiate Keystone XL’s route through Nebraska and Kinder Morgan is awaiting construction permits in British Columbia for the Trans Mountain pipeline.
While prices surged largely due to the surprise shutdown of the U.K. pipeline and tensions in Iran, these factors are not likely to keep prices at these levels for very long. The U.K. pipeline should be back on line by mid-January. Iran is responsible for less than 4% of global oil production and protests did not disrupt exports. U.S. production—close to 10% of the global total—continues to grow. Global demand is likely to slow somewhat, given the higher prices. These factors will put downward pressure on prices.
Other economic indicators
Bank of Canada increased its key interest rate to 1.25% in January
Canada’s economy is operating close to capacity. Inflation is approaching the Bank of Canada’s target of 2%. As such, the Bank of Canada raised it key interest rate to 1.25% on January 17, 2018. The Bank expects the Canadian economy to grow 2.2% in 2018 and 1.6% in 2019.
The Canadian dollar appreciated at year end
The Canadian dollar closed at US$0.7971 at the end of December, up from US$0.7852 at the end of November. Canada’s strong economic growth propelled the loonie higher this year against the greenback. However, the U.S.’s strong growth, stimulus from the recently passed tax plan and the anticipated rate hikes by the U.S. Federal Reserve in 2018 will put downward pressure on the loonie. See this month’s feature article for more analysis.
SME confidence held steady in December
Canadian SME confidence, as shown by the Business Barometer Index compiled by the Canadian Federation of Independent Business, held relatively steady in December, increasing 0.4 points to 59.7 from 59.3 in November. Optimism improved in Alberta and British Columbia, but they still have not reached the high levels of confidence in Quebec, the most optimistic province. Confidence in the finance and real estate and wholesale trade sectors is highest, followed by confidence in professional services, despite the fact that the latter fell 11 points in December. The natural resources sector also saw a big drop of nearly nine points in December. Small and medium-sized enterprises are facing pressure on costs, particularly wages (with a quarter of businesses expecting average wages to rise by 5% or more this year), rising energy prices, and more taxes and regulations. While finding skilled labour remains a challenge, the number of businesses reporting it as a limiting factor on their sales and production declined three points in December.
Credit conditions remain relatively stable
Credit conditions continue to remain relatively stable for businesses. The effective business rate is up 32 basis points since early July, which means that commercial banks have not yet passed on the full 50 basis points in rate hikes by the Bank of Canada. The rate is now slightly above its five-year average.