Goldman Sachs took a hatchet to their forecast for the Canadian dollar, downgrading the short-, mid– and long-term targets by significant amounts. The three-month target for the loonie was cut to 78 cents (U.S.) from 84 cents and the 12 month outlook to 76 cents from 82 cents. Most alarmingly, the Canadian dollar target for 2017 was slashed to 71 cents from 79 cents – a clear sign that Goldman Sachs doesn't expect a recovery in the loonie any time soon.
Goldman's pessimism on the loonie is entirely a function of weak oil prices. Analyst Robin Brooks writes, "the drop in oil prices is on balance a negative for Canada. That negative is not yet fully reflected in the [Bank of Canada's] latest forecast which assumes Brent at $60 … which is why Governor [Stephen] Poloz left another rate cut on the table."
The importance of oil and commodity prices can be seen by comparing the loonie to the Citi Commodity Terms of Trade Index for Canada. The index measures the price of the primary resources, notably oil, that the Canadian economy exports abroad.
The value of the Canadian dollar has closely tracked the terms of trade index in the past five years, but lately has been trying to play catch-up with the rapid decline in the oil-heavy index. As Mr. Brooks noted, the effects of the fall in oil prices is not yet fully captured in the value of the loonie and the currency is likely to fall further if crude prices remain low.
SOURCE: Scott Barlow/Bloomberg
Goldman Sachs also believes the Canadian dollar will weaken further because of a "regime break" in Bank of Canada interest-rate policy. Mr. Brooks writes that, "the BoC in the past has closely followed the Fed but broke with tradition [with the recent cut in the overnight interest rate]."
In the lower chart, which shows the government of Canada two-year bond yield minus the U.S. Treasury two-year bond yield, we can see just how dramatic last week's "regime break" has been.
SOURCE: Scott Barlow/Bloomberg
Mr. Brooks expects that Canadian interest rates will remain lower relative to U.S. rates. The Bank of Canada wants to offset the negative economic effects of the decline in crude prices with cheaper borrowing rates and more credit creation.
These lower domestic rates mean fewer foreign investors will be attracted to Canadian bonds – the bond yields will be lower relative to U.S. Treasuries. This lack of foreign money inflow to buy domestic bonds means less demand for Canadian dollars and further weakening in the currency.
So, weaker energy prices and low bond yields strongly suggest weakness in the loonie for the foreseeable future. For investors, the important implication is that it's not too late to buy U.S. dollar equities until the trends on our charts change direction.
Follow Scott Barlow on Twitter @SBarlow_ROB.