By Michael O’Neill, Agility FX Senior Strategist
The long awaited and highly anticipated Opec oil production cuts are a reality. The two-month debate about whether the planned cuts announced in Algiers on September 28 would ever see the light of day, is over.
On November 30, Opec declared that it would “reduce its production by around 1.2 million barrels per day, to bring its ceiling to 32.5 mb/d, effective January 1, 2017.
Oil price volatility dominated FX markets following the Algiers announcement of planned production cuts and the Canadian dollar was center-stage. Oil prices and the Loonie soared and sank on every rumour and statement from officials or strategists.
There were a lot of naysayers that believed the cartel would never be able to reach an agreement.
They were wrong.
It is only fitting that Saudi Arabia, who’s quest for market share precipitated the oil price freefall two years ago, stifled dissent by accepting the largest per barrel decline, agreeing to reduce production by 486,000 b/d. Even Iran agreed to a cut, albeit just 2.3%. of their current production total. Libya and Nigeria were exempted.
Let the oil rally begin. Not so fast. Opec admitted to concerns about inventories noting that ”the large stock overhang continues to be a major worry”, adding that they are still 300 million barrels above the five-year average.
Although oil prices are well above the February 2016 bottom of $26.14/barrel, they are still below the downtrend line following the November 30, 2014 collapse. Until prices move decisively above the $53.50 area, the risk is for price consolidation in the $46.00-$53.50 range.
As oil price volatility fades from the spot-light, the Canadian dollar becomes increasingly vulnerable to new external and domestic risks.
The biggest risk is US interest rates. A rate hike on December 14 is almost a given. The uncertainty lies in the number of rate hikes that will occur in 2017. Currently, the consensus is for just two increases of a quarter point which would put the Fed Funds target range at 1.00-1.25%. (assuming a Dec. hike)
That estimate may be low.
US President-elect Donald Trump’s trillion-dollar infrastructure spending plan ups the ante. Fed Chair Janet Yellen warned that huge infrastructure spending could stoke inflation. If that shoe drops, rising inflation and low unemployment would force the Fed to increase interest rates a lot quicker than markets are expecting.
That wouldn’t be good news for the Loonie. An increase in the CAD/US interest rate differential would offer added incentive to buy USDCAD.
Such a development would put a smile on the face of Bank of Canada governor, Stephen Poloz. “The BoC does not target the exchange rate” is an oft used comment in speeches and press conferences by the governor and senior officials, although some traders believe that it is said with a tacit, Monty Python-esq “nudge, nudge, wink, wink”.
That’s because for a long time, the Bank of Canada has been forecasting that Canada economic growth will be fueled by an increase in non-resource exports. A weaker currency helps to achieve those goals.
Central Bank governors in Australia and New Zealand are not that shy when talking about their currency’s direction.
The Reserve Bank of New Zealand complained in their November 10 monetary policy statement that “The exchange rate remains higher than is sustainable for balanced economic growth and, together with low global inflation, continues to generate negative inflation in the tradeables sector. A decline in the exchange rate is needed.”
There is nothing subtle about that statement.
The Reserve Bank of Australia acknowledges that “the low exchange rate since 2013 is helping the traded sector”.
It is a bit of a stretch to believe that the Bank of Canada doesn’t share the same view when it comes to the currency.
Mr. Trump’s aversion to the 1993 NAFTA agreement has emboldened the US Lumber Coalition. The are adamant that Canada provides unfair subsidies to the forestry sector which seriously harms the US industry. They appear to have a friend in the Whitehouse. Hostile rhetoric threatening this trade agreement will keep the Canadian dollar on the defensive.
Donald Trump puts NAFTA at risk: Photo: Shutterstock
The Bank of Canada shifted to a doveish monetary policy bias in October with the governor’s pronouncement that “rate cuts were discussed” at his press conference following the rate decision.
Just the thought that Canadian interest rates could be trimmed in the future has put a floor under USDCAD.
There’s more. Donald Trump advocated a corporate tax repatriation holiday during his campaign. He said that corporations with profits in offshore accounts could repatriate them at a one-time tax of just 10%. (the existing rate is 35%). That deal could be attractive to those American companies who have, according to Capital Economics, stashed $2.5 trillion off-shore.
Repatriation flows would add further support to the US dollar and undermine the Canadian dollar.
Widening CAD/US interest differentials, possibly limited near-term upside potential in oil prices, the risk of Canada US trade hostilities and a doveish central bank risk driving USDCAD to 1.4150.
And that is precisely why Loonie bulls are nervous.