Canada's economy has shown signs of slowing in recent months and now international developments could mean it faces further headwinds in 2018.

Bond and interest rate derivatives prices still imply there is a 25% chance of another rate coming from the Bank of Canada in 2017 while bets on even more interest rate rises coming once into 2018 are even heavier.

“We think the market is overpricing the path of rate hikes from the Bank of Canada for now,” says Gek Teng Khoo, a strategist at Morgan Stanley. “The market is pricing in 2 more rate hikes by the end of 2018, but BoC Governor Poloz sounds increasingly cautious in his communications.”

Canada’s economy has slowed recently, with growth turning negative during August after stalling to halt back in July. But markets are yet to fully take account of an increasingly cautious tone coming from Canadian rate setters.

“He [Poloz] cited that CAD gains have been caused by rate expectations and that there is continuing slack in the labor market, meaning inflation could undershoot the BoC’s target 1.5 to 2 years from now,” says Khoo.

Canada’s slowdown follows two back-to-back interest rate hikes from the Bank of Canada between July and September, which saw traders push the Loonie higher against all of its international rivals in the hope further rate increases would be forthcoming.

“We see the upward movement of AUDCAD as further evidence that CAD will underperform other G10 currencies,” Khoo adds.

Recent weeks have seen the Canadian Dollar weaken in response to the poorer growth data and the BoC’s tones of caution, but even those who are still optimistic in their outlook for Canadian rates are beginning to pencil further falls for the Loonie into their forecast tables.

Pound-to-Canadian-Dollar rate shown at daily intervals, capturing CAD weakness and GBP strength.

“Our forecast now assumes the BoC will remain on the sidelines for the next couple of meetings before resuming a tightening cycle in the second quarter of 2018. A slightly slower pace of hikes prompted us to lower our Canadian dollar forecast,” says Josh Nye, an economist at RBC Capital Markets.

Nye notes Canada’s economy has recently come off the boil, in RBC’s latest ‘Financial Markets Monthly’, but plays down the significance of recent data for the medium term outlook.

“We think the slowdown reflects a more sustainable pace of consumer spending, which would be consistent with a moderation in job growth last quarter, the economist writes.

October’s Bank of Canada meeting minutes were not as bad for the Canadian Dollar as the markets appeared to assess, according to Nye, although the urgency that saw BoC policymakers rushing to raise rates in the summer was notably absent from the latest statement.

“We agree that it looks like the bank will be a bit more patient in removing accommodation but continue to think a near-capacity economy calls for higher interest rates,” Nye explains.

Nye and the RBC team now forecast the Canadian Dollar to weaken further against the greenback before the first quarter of 2018 is out.

They project the USD/CAD rate will rise to 1.3000 during this time but will fall thereafter as the BoC resumes its march toward higher rates.

USD/CAD shown at daily intervals. 244 points upside to RBC Capital Markets' forecast.

“The "canary" currencies like NZD, AUD,and CAD should see the bulk of their weakness next year,” says Hans Redeker, head of foreign exchange strategy at Morgan Stanley.

Redeker marks the Canadian Dollar and a range of others as so called “canary currencies”. For a whole host of reasons, these are seen as being particularly vulnerable to weakness in a rising interest rate environment.

But it isn’t just changes in domestic interest rates that can have an adverse effect on this basket.

“As China continues pursuing its financial de-risking strategy post Party Congress, we keep a close eye on local developments,” Redeker notes. “In the past decade, China's investment boom contributed to excess global capacity and low inflation. This could now change as China switches from supply to demand driven growth.”

Canary currencies are at threat from rising rates because the highly indebted economies that underpin them can be expected to, at best, slow down as rates rise.

Some may also be ensnared by higher global funding costs, regardless of what happens domestically, if the countries in question run large current account deficits and/or have banks that are dependent on international financial markets for funding.

“We see this [China] having negative implications for the ‘canary’ currencies, especially those that built up high household debt levels while rates were low and have a shortage of domestic savings, such as AUD and CAD,” says Redeker.

China is stepping up efforts to reign in runaway credit growth in its domestic economy, something that is likely to result in reduced funding for infrastructure projects and therefore, lower commodity demand.

“Many of these economies have direct trade or indirect commodity price linkages to China, such as AUD and NZD. China de-risking may weaken growth and hence moderate its inflation outlook,” says Redeker. However, should China’s economy stay strong then it may come with higher inflation rates, suggesting higher global funding costs which will weaken the 'canaries' via their high debt levels. The 'canaries' may be trapped in a ‘catch-22’.”

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