The Canadian Dollar has overthrown the Sterling as the best performing major currency of the year. But with the Bank of Canada’s (BoC) policy set to evolve in a favorable direction sooner than elsewhere, the Loonie is now a leading contender for a sustained period of outperformance.
Canadian Dollar Overtakes U.K. Pound
Sterling has suffered a setback alongside a softening Euro this month and amid a turn for the worse in sentiment toward European currencies generally. Leading the Pound-to-Canadian Dollar rate back beneath 1.74 and roughly its breakeven level for 2021 to trade as low as 1.72 this week.
Canada’s Dollar has picked up, alongside the U.S. Dollar, oil, and investors’ contemplation of what an economic recovery might mean for Bank of Canada policy in the weeks ahead, helping to make it the outperformer in the 2021 currency market marathon thus far.
“We expect the currency to gain in the weeks ahead (outperform in the G10 space),” says Shaun Osborne, chief FX strategist at Scotiabank.
“Beyond an earlier reduction in its pace of QE, we also expect the BoC to be among the first major central banks to begin raising rates,” Osborne added.
This is after the BoC indicated clearly this week that it intends to begin packing up its crisis-fighting toolbox as soon as next month and at what is a quicker pace than many had anticipated, which is positive for Canadian government bond yields and a prospective boon for the Loonie especially as this would be coming at a time when investors are on the lookout for divergence between central banks’ inflation outlooks and policy stances.
“Even though liftoff may be a long way off, we think divergent policy stances will be an increasingly important factor for G10 FX investors,” says Michael Cahill, a strategist at Goldman Sachs. “In our view, this approaching divergence can be mostly attributed to three factors: initial (pre-pandemic) conditions, the exit strategy process (i.e., balance sheet measures), and some idiosyncratic factors potentially changing policymakers’ reaction functions.”
The Canadian Dollar already offered investors a best of both worlds exposure to commodities that benefit from any global recovery as well as to an inevitable tailwind resulting from Canada’s proximity to a stimulus pumped U.S. economy, but the Loonie’s appeal now stands to be bolstered further.
Goldman Sachs’ research has found that currencies tend to respond to central bank policy changes long in advance of them. The largest currency responses to diverging rate paths are often found in the exchange rates that pit currencies of close neighbors like the U.S. and Canada against each other.
Selling USD/CAD and USD/NOK are among the bank’s top recommended trades for the months ahead and the most relevant for the theme of central bank divergences, recent signs of which could now enhance the Canadian Dollar’s responses to economic data.
This is because when central banks favor either higher rates or bond yields, investors tend to respond more to good and bad economic reports by pricing-in or out future policy changes. Meanwhile, pessimists whose preferences are for lower interest rates or bond yields would typically tend to overlook positive economic news, Goldman says, leading their currencies to become less responsive to it eventually.