By Michael O’Neill

The Loonie was soaring high.  It was December 5; the Canadian dollar traded at 79.20 cents to the US dollar and more than a few traders believed it would reach 80.00 cents, after the Bank of Canada (BoC) policy statement, the next day.

It didn’t happen.  Instead, the Loonie got its feathers plucked.  USDCAD skyrocketed, rising from 1.2655 to 1.2806 in a couple of hours, and continued higher the next day.

The catalyst for the dramatic drop in the value of the Canadian dollar was the Bank of Canada statement.  Not the entire five paragraphs,’ just this one line: “The global outlook remains subject to considerable uncertainty, notably about geopolitical developments and trade policies.”

Aside from the line about uncertainties from trade policies, the Bank of Canada statement was upbeat.  The Bank acknowledged moderating growth that was still above potential in the second half of 2018.  They shrugged off a third-quarter decline in exports and forecast a resumption of export growth.  They noted that “inflation “has been slightly higher than anticipated” and that labour market slack was diminishing.

The statement concluded with: “While higher interest rates will likely be required over time, Governing Council will continue to be cautious, guided by incoming data…”

And therein lies the problem.  FX traders took Bank of Canada Governor Stephen Poloz’s words implying that “rate hikes were data dependent” to heart.  Hence the aggressive USDCAD selling from 1.2905 after better than expected GDP and employment reports on Friday, December 1.

In the December 6 statement, even though the BoC said rate hikes are still data dependent, the concern about trade policies, raised warning flags for those looking for interest rate increases.

Traders decided that the trade policies Mr Poloz was concerned about were not the EU/UK Brexit negotiations, or the TransPacific Partnership but NAFTA.  Press reports suggest that the NAFTA talks are not going particularly well, at least from Canada’s stand-point.  Mr Poloz is worried.  The Governor appears to have shifted focus from data dependency to NAFTA dependency.  If so, a rate hike may not happen until the trade talks conclude.  That helps explain why the probability for a January rate hike dropped to 30% from 50% after the statement.

Meanwhile, south of the border, the market is pricing in a 90% chance that the Federal Reserve will raise rates on December 13, and 50% for another increase in March.  The Fed is forecast to increase interest rates three times in 2018.  Analysts at Goldman Sachs are predicting four hikes.   The ascension of Jerome Powell to the throne of Fed Chair at the end of January supports a bullish bias to the US dollar as he as viewed a less dovish than the outgoing chair, Janet Yellen.  Also, new FOMC board members, to be appointed by President Trump, may give the Board a hawkish bias, adding another layer of support to the currency.  Widening Canada and US interest rate differentials will continue to support US dollar gains.

The next top-tier Canadian economic reports are released December 21 (inflation) and December 22 (October GDP).  The proximity to the Christmas and New Year’s holidays and the BoC’s focus on trade risks will diminish their impact on trading.

External factors will drive Canadian dollar direction for the rest of December and January.

A key factor is the ongoing US tax reform bill.  The negotiations between the Senate and House of Representatives are progressing towards the December 22 deadline.  When (if) passed, the personal and corporate tax cuts are supposed to give the US economy a boost which supports the greenback.

The rising risk of the NAFTA agreement being negated is an enormous concern for the Canadian dollar.

The National Post highlighted five major US demand’s that Canada’s Chief Negotiator Steve Verheul said Canada would not accept.  They were: a) autos need 50% US content and 85% regional content to be tariff-free.  b) The US wants to limit Canada and Mexico access to government contracts.  c) America wants to get rid of the existing third-party dispute settlement process.  d) American’s want the agreement to expire after five years.  e) Canada must eliminate all tariffs on poultry, eggs, dairy.

Canada’s bargaining position was worsened this week after Prime Minister Justin Trudeau’s trade-deal-seeking trip to China failed.  Chinese officials saw the ploy for what it was; a blatant attempt use China as leverage in the NAFTA talks.

Prime Minister Trudeau proved once again that while he is adept at selfies and delivering teary-eyed apologies to anyone, anywhere, at the drop of a hat, when it comes to the world stage, he is just scenery.