We expect oil to be the key driver for the loonie - Capital Economics
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We expect oil to be the key driver for the loonie

Global Markets Update
Written by Jonathan Peterson
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Given our latest forecast for oil prices, we now expect the Canadian dollar to rise further in 2021 than we previously thought, but to drop back a bit in 2022.

 

  • Given our latest forecast for oil prices, we now expect the Canadian dollar to rise further in 2021 than we previously thought, but to drop back a bit in 2022.
  • Despite already rising more than 15% against the US dollar from the last year’s low, we think the outlook for the Canadian dollar remains bright for the rest of 2021. For one, in our view the loonie was undervalued as the crisis began, so it is not yet at a level that would imply overvaluation. (See Chart 1.) Additionally, we forecast that the spread between 10-year government bond yields in Canada and the US will disappear this year. (See Chart 2.) At the margin, we think this may provide some support for the loonie.
  • Above all, we expect higher oil prices to continue to benefit Canada’s economy. The swift rebound in oil prices already appears to have driven a full recovery in Canadian oil production which will, in our view, lead to an unexpected rise in Q1 GDP, despite the tightening of virus restrictions. We expect this strength from the natural resources sector to continue as the global economy recovers, and our end-2021 forecast is for a further rise in the price of WTI crude oil to $67 per barrel (pb), from ~$63 pb now. (See Chart 3.)
  • That said, we are not convinced that such a high level of oil prices will be sustained and expect higher levels of global production to push down the price of WTI crude oil in 2022. Our forecast for the end of that year is $53 pb. (See Chart 3 again.) While we do not anticipate that a lower oil price will result in a change next year in the spread between 10-year government bond yields in Canada and the US (see Chart 2 again), we think that it may dampen investors’ expectations for an earlier interest rate hike from the Bank of Canada than from the Fed. (See Chart 4.) If we are right, that could also weigh on the loonie.
  • The upshot is that we are raising our end-2021 forecast to US$0.84/CA$, from $0.82, but are revising down our forecast for end-2022 to $0.82, from $0.85.

Chart 1: Percentage Deviation from 7-Year Average
Of US$/CA$ Real Exchange Rate

Chart 2: US$/CA$ & 10-Year
CA-US Sovereign Bond Spread (pp)

Chart 3: US$/CA$ & WTI

Chart 4: Policy Rate Implied by OIS (%)

Sources: BIS, Refinitiv, Bloomberg, CE


Jonathan Petersen, Markets Economist, jonathan.petersen@capitaleconomics.com