The loonie is trading above 76 cents to the U.S. dollar for the first time since February and economists believe there’s still room to run before the Bank of Canada inevitably ends the rally.

The Canadian currency began to pick up  momentum in the week of June 17th in anticipation of the U.S. Federal Reserve’s update on monetary policy. Since Fed chairman Jerome Powell’s dovish tone suggested the central bank could entertain a rate cut, the loonie has gained nearly two cents to the greenback, trading at US$0.7623 on June 26th.

TD Securities senior FX strategist Mazen Issa attributed much of the rally to the Fed’s announcement as well as the narrowing between Canadian and U.S. two-year bond yield spreads. Unlike the Fed and other central banks that have adopted a more dovish tone or even cut rates, the Bank of Canada has not signalled its intent to follow — nor does it immediately need to, he said.

“We’re probably in a world now where momentum will continue to support (Canadian dollar) appreciation,” Issa said. “This is going to be an exercise to discover the Bank of Canada’s pain threshold.”

Issa isn’t projecting a Bank of Canada rate cut until January and in that time his projections have the loonie reaching 78 cents to the greenback. The current rally could take the currency to as high as 80 cents, he said. At that level, the Bank of Canada may be pressured to consider adopting a more dovish outlook due to the effects a rapidly rising currency might have on trade. A second cut in 2020 might even be possible in that scenario, Issa said.

The Bank of Canada can only deviate from the Fed for so long, RBC Global Asset Management chief economist Eric Lascelles said.

“I’m not convinced we’re going to decouple from the U.S.,” Lascelles said. “Really, the story is one in which I don’t think Canada is that different from the U.S. after all.”

Over the next two months, Lascelles can see the loonie rallying to as high as 78 cents to the greenback, but is less optimistic when he extends his outlook. In the following one to two years, he said, the loonie is poised to give back all it has gained and likely more as it hovers between 71 cents and 77 cents.

But the lower levels of that range could become a reality far sooner, according to Capital Economics senior Canada economist Stephen Brown, if the Bank of Canada cuts rates in October, as he projects.

FX markets are currently pricing too much easing from the Fed, Brown said, and one rate cut for the Bank of Canada. After Powell’s press conference last week, some expected the Fed could soon announce a cut of 50 basis points.

That’s unlikely to happen, he said. Instead, he believes the Bank of Canada will follow the Fed and announce the same cuts. The Capital Economics team is also forecasting an end to the U.S. equities rally, which it believes will soon begin to move in reverse.

In that event, the loonie, which is a riskier asset to own, would further depreciate because investors would likely funnel funds back into the safe haven of the U.S. dollar.

By the end of 2019, he expects the loonie will be trading at 72 cents to the greenback.

Source: Financial Post