July 24, 2019 / 1:18 PM / 3 months ago

Loonie rally tests Bank of Canada resolve to diverge from global peers

TORONTO, July 24 (Reuters) - The Canadian dollar, this year’s best performing G10 currency, is threatening to ruin the Bank of Canada’s plan to sit out global interest rate cuts, after a rally since May that risks undercutting an expected pickup in exports.

The loonie has rallied as much as 4% against the greenback over the past two months as the Bank of Canada made clear it had no intention of cutting interest rates, even as other central banks, including the U.S. Federal Reserve, have eased monetary policy or have signaled plans to do so.

Strengthening of the loonie could make the country’s exports of autos, maple syrup and other goods more expensive in international markets, lessening the likelihood the Bank of Canada would diverge for too long from its global peers, according to some economists.

“A stronger Canadian dollar could be the catalyst that pushes the central bank into a token ease in 2020,” said Royce Mendes, a senior economist at CIBC Capital Markets. “Exports have struggled to gain traction when the loonie was weaker than it is today.”

Canada’s central bank is relying on increased exports to make up for expected cooling in consumer spending, but non-energy exports, a measure of the sector’s underlying strength, have made little headway since 2015.

(See exports graphic here tmsnrt.rs/2XVbE69)

PAIN THRESHOLD

Non-energy exports climbed in May, the latest month for the data, but some forward looking indicators are not encouraging. The IHS Markit Canada Manufacturing Purchasing Managers’ index (PMI )showed that Canadian factory activity contracted for the third straight month in June as global trade frictions weighed on sales.

A small worsening in the outlook for exports could be enough to undermine the Bank of Canada’s projection for economic activity to grow at a pace over the coming years fast enough to eliminate slack in the economy, said Stephen Brown, a senior Canada economist at Capital Economics.

He added that the Bank of Canada could warn markets about the strength of the loonie if the currency were able to sustain a move to 77 U.S. cents.

On Friday, the currency notched a near nine-month high at 1.3016 to the U.S. dollar, or 76.83 U.S. cents, a level that was well above the 75 U.S. cents rate that the Bank of Canada used in its forecasts as the benchmark interest rate was left on hold at 1.75% this month.

The Canadian dollar was also trading near 77 U.S. cents in January 2017 when the Bank of Canada worried that broad-based gains for the currency would add to competitiveness challenges.

“I think this is essentially going to become an exercise in discovering the pain threshold for the Bank of Canada,” said Mazen Issa, a senior FX strategist at TD Securities. “If the Fed cuts there will be a natural policy pressure for the Bank of Canada to move that way.”

Money markets expect the Fed to cut interest rates at the end of the month and at least once more by year-end.

Reporting by Fergal Smith; Editing by Steve Orlofsky

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