Foreign Exchange analyst explains why his firm predicts a weak Canadian dollar and how it reflects a possible recessionary environment
The Canadian dollar is a global growth currency. For all the complexity in our economy, the old trope of Canadians as ‘hewers of wood and drawers of water’ still holds true on foreign exchange markets. When the world is growing, it needs Canadian lumber, minerals, and hydrocarbons — not to mention Canadian industrial goods. When the global economy struggles, the market for Canadian exports dries up, and the CAD struggles.
While that is, in some ways, a significant oversimplification, that dynamic is currently playing out on currency markets as global investors take a bearish view on CAD. Jay Zhao-Murray, FX analyst at Monex Canada, recently authored a paper outlining why his firm expects weakness in the Canadian dollar. Global economic slowdowns and heightened geopolitical insecurity are key to that shift, but so too is the high likelihood that Canada will enter — or has already entered — a recession.
“We think the [geopolitical] risk environment is going to stay fairly negative going forward, but even then we have a neutral forecast for the next three months, but we see the Loonie weakening further in the first half of next year,” Zhao-Murray says. “The main reason for that is we think the Canadian economy has weakened. There are several signals telling us that at least a mild recession is likely.
“We think that if a recession occurs, the Bank of Canada will likely be forced to cut rates earlier and more aggressively than the Fed, and that scenario is not currently being priced into markets.”
A growing interest rate differential with the BoC cutting sooner, Zhao-Murray explained, should put downward pressure on CAD and upward pressure on the US Dollar.
What a currency outlook says about a recession
The current geopolitical environment may offer some short-term respite for CAD, however. Zhao-Murray noted that the current conflict premium on oil could be positive for CAD, and an escalation in the conflict could spike oil prices higher, which could improve CAD performance against currencies like the Euro. The USD, however, is also viewed as a safe haven asset so much of the conflict premium oil, and by extension the CAD, would receive wouldn’t be reflected in marked improvement against the US dollar.
Zhao-Murray’s longer-term bearishness on CAD is tied to the possibility of a recession. While he thinks we aren’t quite in a recession yet, he notes that Canada has been essentially stagnating since January, while increasing its population significantly through immigration. Those immigrants have improved Canada’s productive capacity, but they’ve added more to incremental demand which has kept the Canadian economy from falling into a recession on an aggregate basis — while we may already be in a recession on a per-capita basis.
That per-capita recession is reflected in a few key datapoints. Canadian domestic demand is falling as Canadians cut spending on restaurants and recreation. According to the latest consumer survey, 60% of Canadians have been cutting back on discretionary expenses to cope with inflation. Firm sales outlooks, too, have been weak and surveys say that firms plan to hire less and invest less.
The big domino yet to fall, Zhao-Murray says, is the overall labour market. He’s waiting for more unemployment data, survey results from the BoC, and any pullback on the net issuance of visas to see what kind of a recession we may be headed towards.
What will this recession look like?
At the moment, Zhao-Murray believes any Canadian recession we hit should be relatively mild. He notes that while firms are looking to invest and hire less, they’re also largely trying to keep the staff they currently have. Corporate margins are compressing, but they’re still profitable. The struggle many firms faced trying to re-hire post-pandemic may mean they end up hoarding labour, which should keep any recession from spiralling out of control.
As advisors look for assets and exposures that can help them navigate a looming recession, Zhao-Murray believes that a specialized hedging strategy can help. The USD has already shown strength, as it tends to in uncertain times, while many other currencies may become useful hedges against CAD exposure or CAD-denominated assets.
Until a recession is finally confirmed, Zhao-Murray is watching a few key datapoints to validate, or challenge, his outlook. He believes that concerned advisors should be doing the same.
“A big area to keep watching are the signs telling us whether this demand growth is continuing,” Zhao-Murray says. “Our view is pretty well predicated on a growth slowdown coming in, softening inflation, and cuts from the Bank of Canada. However, depending on how inflation data goes, there are still risks. We could be seeing a stagflation dynamic because wage expectations are still high. I think advisors need to stay on top of the developments in inflation, watch the indicators for domestic demand, and see how that rolls on from here.”
