Weakness in Canadian dollar since the beginning of the year intensified after the FOMC minutes unveiled rigorous debates about an early exit of asset purchases. A more hawkish minutes together with concerns over sequester beginning in March have increased concerns over the loonie due to the close relationship between economies in Canada and the US. Domestically, the economy has lost momentum with real GDP expanding less than +1% (annualized) in the second half of 2012. The moderation was driven by more cautious household spending, softening in the housing market and ongoing fiscal restraint. These issues are expected to weigh on Canadian dollar. Moreover, despite persistence of interest rate differential between USD and CAD, recent comments from the BOC suggesting that a rate hike is less imminent than before also is a negative factor for the loonie.
The FOMC minutes for the January meeting indicated that policymakers were more upbeat on the US economic outlook as driven by improved business confidence and household consumption. They acknowledged better employment conditions but stressed that 'the recovery in the labor market was far from complete'. The debate on additional QE remained rigorous but balanced. The focus was on the benefits and costs of additional asset purchases. While some suggested asset purchases to end 'well before the end of 2013', others warned of the 'significant' costs of ending purchases prematurely. The discussion raised concerns that the Fed might end QE earlier than previously anticipated. Worse still, the exit would be accompanied with a still tough economic environment as sequester involving spending cut of US$ 85B from the government's US$3.8 trillion operating budget
At the last BOC meeting, policymakers reaffirmed that 'the modest withdrawal of monetary policy stimulus will likely be required over time'. Yet, 'the more muted inflation outlook and the beginnings of a more constructive evolution of imbalances in the household sector suggest that the timing of any such withdrawal is less imminent than previously anticipated'. In coming meetings, we expect the central bank would reiterate this stance, citing issues such as household imbalances, ultra-low inflation and a widened forecast for the output gap as factors delaying tightening.
The above factors are expected to weigh on the Canadian dollar this year. Yet, interest rate differential as inflows of foreign capital attracted by Canada's triple A rating should be able to lend support to the CAD