[Dan]

No QE/CE yet but probability remains high
The Bank of Canada made a deliberate attempt to slow the rise in the Canadian dollar in the statement accompanying its decision to leave rates at the effective lower bound of 0.25%. This comment implies that the bank may opt for quantitative easing (QE), if there is no further improvement in financial conditions sufficient to offset the punishing effects of the dollar’s rise.

The BoC’s concerns that the markets are getting ahead of themselves in pricing in a global recovery rang loud and clear in the statement. The Canadian dollar’s 'unprecedented rapid rise' could 'fully offset' the recent improvement in other financial conditions, according to BoC analysis. More broadly, the bank’s outlook for the domestic and global economy was an unchanged assessment that the recovery would 'be more muted than usual'.

Restructuring to increase slack in economy
One change to the BoC’s outlook was the mention of restructuring in a number of sectors. While the bank noted this factor in the April Monetary Policy Report, this week’s comment made the more overt point that restructuring would be negative for both production and supply. The restructuring could, as a result, lead to a widening in the output gap despite the fact that shuttered capacity could reduce
potential GDP growth. (A rule of thumb is that a restructuring is a two-thirds hit to actual GDP and a one-third hit to potential GDP, so the net result is a widening in the output gap.)

Conditional commitment unchanged
Despite the policies put in place, and balanced risks to their growth profile, the bank judges that the risks to inflation remain slightly to the downside. As such, it made no change to its conditional commitment to leave rates at the effective lower bound until mid-2010. The risks are skewed to the downside, which is another reason that the possibility of the bank implementing further quantitative or credit easing is higher than the market is currently discounting.

[Pimpllus]

On June 11, BoC Governor Carney is sure to face more intense scrutiny with regard to FX developments. While the BoC is unlikely to take any action soon, they are not indifferent to USD/CAD moves. In particular, declines in USD/CAD from current levels (1.10) would become an increasing risk to a Canadian economic recovery and will increase the risk of an eventual BoC counter strike.

Bank of Canada Governor Carney’s speech and press conference this week (Thursday June 11) offer a chance to more fully discuss recent FX market developments, and the “unprecedentedly rapid rise in the Canadian dollar in May” — an 8.2% drop in USD/CAD, with USD having its largest impact on Canada’s effective exchange rate in over 10 years. The BoC avoided conjecture in the press statement on June 4, but Carney won’t be able to avoid pointed questions on the potential impact of the sharp decline in USD/CAD on the Canadian economy. In particular, any “good news” for Canadian manufacturers from the move in USD/CAD from near parity last fall to readings consistently above 1.20 until the end of April, is at risk of being blown to smithereens, as might any hope of a Canadian economic rebound in 2009 or 2010.

The focus on Mr. Carney comes as the market knows he has few options. Offsetting FX moves with interest rate cuts is not possible, with rates at the effective lower bound and likely to stay there into 2010. The BoC considers sterilized FX interventions to be “generally ineffective.” An unsterilized intervention would be equivalent to quantitative easing to which the BoC has shown clear aversion.

The BoC does reserve the right to intervene to counter “disorderly market conditions,” but it is not clear that recent moves cross the disorderly Rubicon. General USD weakness is not, by itself, sufficient to spark the first unilateral intervention since August 1998. Between September and October 2007, USD/CAD tumbled 10% (13% April//May 2009) breaking through parity for the first time since late 1976 on the way toward 0.9059 in early November 2007. The BoC’s October 2007 MPR highlighted that “recent movement partly reflects the broad-based weakness in USD” and that “the recent appreciation appears to have been stronger than historical experience would have suggested.” Yet the BoC did not step in, although rate cuts did begin in December 2007.

Even so, it is crucial to discuss the threat USD/CAD poses to the economic rebound and how the BoC might eventually respond. While, the spike in USD/CAD in late 2008 eased the intense competitive pressure on Canada’s factory sector for the first time in years, the recent slide will prevent further competitive gains. A persistent sell off from here would truly turn the screws on Canadian manufacturers at a time of a massive structural adjustment in the auto sector that will weigh on the factory sector overall. Similarly any hoped for “good news” for Canadian GDP from net trade is under intense threat should USD/CAD decline toward parity and beyond.

[Pimpllus]

USD/CAD has taken big tumble over the past few days; there were some warning signs in the middle of last week that the CAD rally may be faltering but Friday’s extension may effectively put a lid on the CAD for the moment at least. Weekly technical patterns have turned USD supportive and though the underlying trend remains towards a softer USD in the medium term, the fall in funds from the 1.17/1.18 area had been largely correction free and a period of consolidation now looks likely. Commodity prices have slipped back and equity prices are lower this morning – supporting the general trend towards softness in the commodity block and firmer USD tone. Traders remain of the opinion that Canada’s relatively stronger structural position – contained Federal debt and deficits along with limited current account deficits – should combine to provide the CAD with solid protection in the medium term and suspect that despite the short term gains seen over the past few days, USD sentiment will remain rather fragile in the face of the mounting debt load and policy uncertainties in the US. In the short term, the USD has bounced hard though and that it may well continue. Technically, USD/CAD resistance now in the upper 1.12/low 1.13 zone; the current bear trend channel ceiling at 1.1263 has come under a little pressure intraday already but the hourly pattern does hold out the prospect of an interim or intraday high having been reached just under 1.13 this morning. Expect solid support on dips for the moment though, with initial buyers now likely to try and scale into USD longs from the low/mid 1.11 area.