The ground has begun to crack under the feet of the traditionally renowned Canadian dollar. The risks of a US-Canada trade war, significant interest rate cuts by the Bank of Canada (BoC), the weak outlook for oil prices and, now, political turmoil have seriously diminished the status of the loonie as the safest option in the high beta, i.e. higher risk, commodity currency space.
At the intersection with the US dollar, The Canadian dollar has fallen more than 8% in the last 12 monthserasing more than 6% in the last three months and now standing at 1.44 ‘greenbacks’. For most of 2024, the decline was mainly due to the widening of the differential between the rates of one country and another given the divergence of monetary policy between the US Federal Reserve and the BoC. Until November, this was fully justified from a macroeconomic point of view: lower inflation and lower growth in Canada relative to the US had led to earlier and faster cuts from the BoC.
However, in November something else went ‘clack’: the election of donald trump as president again in the US and his bellicose rhetoric regarding the imposition of 25% tariffs on Canada have added a new level of uncertainty for the currency. Added to this in recent weeks is a far-reaching political crisis in the government headed by Justin Trudeau and which appears to be ending it.
In a note to clients before Christmas, ING currency analysts already warned of the crater that was opening under the loonie. The report written by strategist Francesco Pesole points out as the clearest symptom of the change in sentiment around the Canadian currency the rising implied volatility of the same in relation to historical volatility, a measure of the market’s perceived risk of broader currency movements in the future. That ratio right now is higher for the Canadian dollar (1.39) than for any other G-10 currency when taking the six-month time frame. This contrasts sharply with the generally low nature of the volatility of the loonie. If the initial Covid shock between February and March 2020 is excluded, you have to go back 10 years (October 2014) to see an implied/historical volatility ratio for the Canadian dollar equal to or greater than 1.40.
In his analysis, Pesole begins by putting his index finger on Trump. His tariff threats, accusing Canada of not collaborating with the US in matters such as immigration control or the fight against drug trafficking, have generated a risk premium which ING analysts estimate at approximately 2% at current US dollar/Canadian dollar levels. “That is, the excess appreciation of the USD/CAD that is not justified by market factors such as rates, equities or commodities, but is related to an additional bearish force acting on the looniein this case, the tariff risk,” explains the expert.
This risk premium must be placed in its historical context. It is currently at the upper limit of the standard deviation level of 1.5. When trade tensions between the US and Canada increased in mid-2018 ahead of the renegotiation of the NAFTA free trade agreement (later renamed USMCA), that risk premium peaked at around 2.5%. That time, however, the US tariffs only affected Canadian steel and aluminum.
Now, the risks for the loonie They are materially larger this time compared to 2018Pesole warns: “Trump is sounding more aggressive on protectionism and the explicit threat of 25% tariffs on all Canadian exports is a very serious risk for Canada’s economy, which depends largely on exports to the US. It is widely believed that US tariffs would send Canada to the recessionand the reaction of an increasingly growth-oriented Bank of Canada could be to cut rates further.”
The ‘snowball’ effect
The facts confirm it. The BoC’s latest efforts have been aimed at giving a breather to a very rate-sensitive economy before any possible protectionist impact. No G-10 central bank has cut rates more than the BoC this year (175 basis points in total), and the bond market swaps It foresees two more cuts in 2025 to 2.75%. “The BoC’s flexibility on the accommodative side, based on growth concerns, could easily trigger a new bearish trend in the Canadian dollar curve and further depreciation of the same should protectionist fears materialize,” emphasizes the ING analyst.
In a medium-term scenario, Pesole does not rule out a movement towards 1.50 in the coming months if the policy differential between the Fed and the BoC widens even further, especially in a trade war scenario between the US and Canada. However, the expert adds, another 4-5% appreciation of the USD/CAD would lead the pair to an overvaluation that would exceed the upper limit of 1.5 standard deviations. “A sudden jump towards overvaluation of a currency with historically low volatility like the loonie carries a greater risk of a rapid correction, unless it is accompanied by a sharp deterioration in economic fundamentals (the long-term drivers of a currency)”, points out the currency strategist.
In his outlook, Pesole warns of the risk of reaching a scenario with the Canadian currency at 1.50 and a red-hot trade war (the 25% tariffs introduced by Trump). At that juncture, “we could see a ‘snowball’ effect in which BoC to cut rates further to support economy hit by tariffseffectively adding depreciation pressure on the loonie“Trump could, Pesole goes further, then protest the weakness of the Canadian dollar by calling it a competitive advantage, as he already did with the yuan and China in 2018. If that resulted in more US tariffs, the loonie would continue to depreciate, potentially beyond the 1.50 mark.
Local politics, a dangerous card
If Trump’s first voices, even without having entered the White House, have hurt the loonie (the elected president of the United States has even told Canada that it would be better off being another state of the United States), the internal political crisis that the country is experiencing rounds off the perfect storm that has formed over the currency. In December, the surprise resignation of the Minister of Finance, Chrystia Freeland, due to friction with Prime Minister Trudeau, precisely around budgetary measures in the face of tariff risks, has greatly increased the chances of an electoral preview of legislative elections. scheduled for October 2025.
Things have continued to accelerate in the days since. Shortly after Freeland’s resignation, Housing Minister and rising star of Trudeau’s party, Sean Fraser, announced that he would not run for re-election. Within days, the Liberals suffered a crushing defeat in British Columbia’s special election, their third of the year.
In the face of all these ‘fires’, all attention is now focused on whether the liberal Trudeau, in power since 2015, will throw in the towel and will leave politics or whether he will opt for a fourth term when the division over his continuity is already evident in his ranks. The media suggests that at least 60 Liberal deputies would be willing to sign a letter calling for his immediate resignation. Even if that strategy fails, the prime minister could face another vote of no confidence in Parliament.
The last surveys strongly suggest that the next government will be conservativewith opposition leader Pierre Polievre as prime minister. “The re-election prospects of the Liberal Party are in tatters. In the absence of a big change in the polls, it is no longer a question of whether the conservatives will win the federal elections scheduled for October 2025, but by how much,” he writes in a client report Bradley Saunders, analyst at Capital Economics.
“Polievre is politically closer to Trump, which in the long term could bode well for the Canada-U.S. relationship, although he recently called Trump’s tariff threat unjustified and said trade retaliation is a possibility,” They make a first layout from ING. Polievre’s political agenda focuses on a more lax fiscal policy and in the increase in the production of energy resources, both positive aspects for the Canadian dollar in the medium term. However, ING warns, its ability to renegotiate the USMCA and reduce trade tensions with the US would inevitably be the main channel for the impact on currencies.
“A Conservative government can be expected to scrap the carbon tax and further reduce immigration. With the budget deficit largely under control, any spending cuts would likely be largely offset by tax cuts, resulting in to a somewhat more restrictive fiscal policy. The net result could be a slightly looser monetary policy than would have been the case under the Liberals,” concludes Saunders from Capital Economics. Paradoxically, a laxity that would help push down the loonie.
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