Can We Have a Strong Loonie with a Bad Economy?

There is little doubt that the Canadian economy has continued to soften. Heightened business uncertainty has already begun to weigh on the labour market. The housing market has also rolled over, particularly in Ontario. The latest trade data suggests exports have taken a worse than expected hit from tariffs.

Despite this, the Canadian dollar has strengthened against the US dollar, rising by about 3% since “Liberation Day.” This is particularly surprising because market-implied interest in Canada fell relative to US rates, which typically lowers the exchange rate.

Is this a temporary overshoot? No. In fact, we expect this divergence to increase in the coming months. The Canada–US spread is set to widen according to our rates strategists, but we believe the trading ranges in USDCAD will keep drifting lower—to 1.35 by the end of this year and 1.30 by the end of next year.

Exchange rates are relative prices. We would frame our forecast as the US dollar becoming weaker rather than the Canadian dollar getting stronger.

There are several macroeconomic forces pointing in this direction:

• The US enjoyed faster growth than other advanced economies post-Covid. This has changed. Consensus forecasts for US GDP have fallen sharply and converged with expected growth in other advanced economies.
• The US dollar has become positively correlated with stocks, especially since “Liberation Day.” In other words, it has lost its safe haven appeal. This matters because many Canadian institutional investors who did not hedge the currency risk on their US investments are now being forced to raise their hedge ratios.
• The Trump administration says it wants to raise the income share of American workers. Telling Walmart to “eat the tariffs,” raising steel and aluminium tariffs to 50% and threatening Apple with a 25% tariff on globally sourced products are the latest indications of President Trump’s intentions. But foreign portfolio investors didn’t sign up for this. They want companies to focus on delivering profits. To many investors, American capitalism now resembles Chinese “common prosperity.”

Where could we be wrong? We could be wrong if we’re mistaking short-term disruption for a regime shift. Specifically:

• The US economy could beat economists’ predictions yet again. Widespread predictions of a recession in 2023 proved inaccurate.
• Carry is a powerful driver of currency flows. The US dollar still offers the highest deposit yields in the G7, which will probably continue for several months as the Fed stays on hold. The US dollar carry trade could revive.
• Market positioning has shifted. Fast money has turned from USD bull to USD bear positions via currency derivatives. In the options market, traders are protecting themselves against a falling US dollar by buying USDCAD puts. Foreign portfolio managers have cut their US holdings in favour of other markets. Investors with a short time horizon could be wrongfooted if the US dollar were to rebound.

Net-net, a strong loonie is the result of a shift in global capital flows leading to a broadly weaker US dollar. For the Canadian economy, this is creating an unwelcome tightening of conditions, especially for the export sector, at a time when the domestic economy continues to look very frail. Consequently, we believe the Bank of Canada will be forced to pivot and cut rates another 75 basis points this year.