Don't get "loonie" over a weak Canadian Dollar

Executive summary:

• With the Canadian economy lagging, the Bank of Canada could cut interest rates sooner and by more than the U.S. Federal Reserve, leading to concerns about how the Canadian dollar may fare
• The loonie is already undervalued on a purchasing power parity basis and rate cuts won't help
• However, once global growth picks up the currency should recover so a longer-term view is crucial

With expectations mounting that the Bank of Canada (BoC) could cut its target interest rate earlier and by more than the U.S. Federal Reserve (Fed), investors are questioning the implications for the U.S. Dollar (USD) to Canadian Dollar (CAD) exchange rate (CADUSD).

Historically, the CAD has performed well when the global economy is growing. That environment benefits Canada's commodity exports, which in turn supports the currency. Although the strength of the U.S. economy has buoyed global growth, the Canadian economy is sputtering, and we believe the BoC is poised to cut its target rate several times in 2024. With the markets now anticipating only two rate cuts by the Fed, the dichotomy between the Fed's policy outlook and the BoC's will likely pressure the CADUSD exchange rate.

The chart below, from our recent Economic and Market Review (EMR), highlights that the Canadian dollar is more than 10% undervalued on a purchasing power parity (PPP) basis. However, due to the divergent central bank policies, it is unlikely to appreciate anytime soon. Therefore, we believe the Canadian dollar will continue to trade in a range between 70 to 74 U.S. cents.

Source: LSEG Datastream, Russell Investmensts. As of April 30, 2024. PPP= Purchasing power parity

A weak currency raises the price of imports, thereby adding to inflationary pressure. However, we believe the Canadian economy is at risk of stagnating or slipping into a mild recession over the next 12 to 18 months. Therefore, a weaker CAD functions as a stabilizer for the economy as it supports the nation's exports. Moreover, it's common to expect a recession to lead to a weaker CAD and disinflation due to lower domestic demand, as shown in the chart below. While the BoC cannot dismiss a weaker currency's impact on inflation, that would not necessarily prevent it from cutting rates to offset recessionary risks.

Source: LSEG DataStream, Russell Investments. As of March 2024. Shaded area represents US recession dates. US recession is used as a proxy for recession/weak global growth environments and due to Canada’s close economic linkages with the US economy.

Over the medium term, however, there is reason for optimism. As noted, the CAD is undervalued relative to the USD by more than 10%, and once the domestic and global economies emerge from the slowdown, the CAD should benefit from improving global growth.

The bottom line is that the loonie is behaving as we would expect. The CADUSD will likely stay weak while the growth uncertainty hangs over the domestic and global economies. However, prospects should improve once the turbulence has passed.