02:31 PM EDT, 05/10/2024 (MT Newswires) -- Avery Shenfeld in his weekly 'The Week Ahead' column said the team at CIBC is getting a lot of questions about the risk of a plunge in the loonie if the Bank of Canada "outguns" the Fed on rate cuts this year. He said CIBC sees a couple of cents of weakening ahead, but "not a sustained devaluation, because of a counterforce" that could support the Canadian dollar against the greenback in 2025.

But, Shenfeld added, the CIBC team is watching another development, across the pond in Europe, that could leave the Canadian dollar more exposed.

Shenfeld wrote: "While monetary policy divergences can impact the Canadian dollar, its broadest movements against the greenback have more often been a reflection of whether the US dollar is generally weakening or strengthening against a basket of major currencies. The euro is the most heavily weighted developed-currency alternative to the greenback. As a result, in the past two decades, there's been an 85% correlation between monthly average levels for the euro's exchange rate versus the USD and the Canadian dollar's valuation against the greenback.

"Hence our forecast for a recovery in the euro next year, and a general weakening in the US dollar, is key to our view that the loonie will reverse the weakness we'll see if the BoC eases more than markets now assume while the Fed stays closer to current expectations. The euro seems poised to rally because the greenback has been bid up aggressively on its usual safe-haven status during troubled economic times globally, to the point where it looks overvalued on trade fundamentals, and vulnerable to the mean reversion we typically see after long runs against the basket of other major currencies. We have both the Fed and the ECB easing more than market is currently pricing-in, with the extra rate cuts on the same order of magnitude, and therefore not having much sway over dollar-euro.

"There's a risk to that call, however, and one that Canadian dollar traders may not be thinking about with all the focus on Canada-US interest rate differentials. Back in December, EU member states agreed to reimpose fiscal guidelines after setting such restraints aside when the pandemic and the Ukraine war hit growth prospects. That will require countries with deficits above 3% of GDP or debts over 60% of GDP to set a path back to those benchmarks, entailing varying degrees of fiscal belt tightening across the eurozone.

"Of course, we've seen European countries claim that their budgets met earlier stability targets, only to beg for forgiveness when they fall short. Such slippage seems likely to repeat, and the EU doesn't have a lot of teeth on the enforcement side. That may be why the IMF sees the eurozone's cyclically-adjusted deficit falling by only 0.2% of GDP next year, not a big enough drag to really substitute for a lot of the central bank easing we expect to see. But if member states really do find religion on fiscal discipline, the resulting hit to growth could see the ECB forced to ease more than we expect.

"In contrast, the IMF has the US cyclically-adjusted deficit actually widening, from 6.7% this year to 7.1% of GDP in 2025. That 0.4% of GDP move is not a huge dose of stimulus, but at this point, with an election in the offing, nobody can really be too sure about that prospect. Donald Trump seems to be pushing for further tax cuts, and Congress hasn't been able to pass much in the way of spending restraints.

"Should US fiscal policy get even looser than we expect in 2025-26, and the EU crack down harder the other way, that could be enough to have the ECB surprising with more rate cuts than our current forecast, while the Fed has to ease less aggressively than our call. That's the sort of surprise that could prolong current US dollar strength. And as we noted, a strong dollar against the euro has gone hand in hand with gains for the greenback against the loonie. So odd as it might seem, keeping an eye on budget decisions in Germany, France, Italy and other major eurozone members is of importance for those with Canadian dollar risks to hedge."

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