Risk, not trade, is what matters for USD/CAD post Brexit – TDS

Mark McCormick, North American Head of FX Strategy at TDS, suggests that the question for many investors is what are the contagion links from Brexit to USD/CAD and the Canadian economy.

Key Quotes

“There are three links (economic, financial and political) and only two of three matter for USD/CAD with the impact reinforcing our call USD/CAD to retest 1.35 in Q3. The 200dma sits near 1.33 so a break of that levels sets up an immediate objective of 1.35 – also our yearend forecast.

The critical link between USD/CAD and Brexit runs through the economic channel but more through the US than the Europe. Indeed, the first chart shows the average five-year share of Canadian exports to individual countries (as a percentage of the total). The US accounts for the bulk of exports at close to 80%. Exports to the UK only account for around 3.9% of the share over the past five years. What’s more, the most recent data from 2015 show Canada drifting away from the UK with the export share slipping to 3.6% from 3.9%, suggesting trade links are starting to dwindle.

This argues that despite the broader slowdown in Europe direct spillovers to Canada are limited. The focus, therefore, should shift to the impact on the US—Canada’s largest trading partner. TD looks for about a 20bp drag on the US economy over the next year based on the implications from Brexit. This is not a large shock but it comes at the wrong time. Notably, the BoC has focused for some time on the pickup in external demand to help the rotation from energy to non-export exports. This rotation has been rocky, at best, and forward-looking indicators suggest US demand is decelerating. This complicates their narrative and the string of weaker trade reports argues for a possible shift in tone from the BoC next week, adding another headwind to CAD.

We still think risk appetite is the most immediate trigger for CAD weakness. Our recent piece argued that CAD is currently the high-beta G10 currency in the G10. This reflects in part market positioning, links to oil, and a negative capital flow position, all of which are exasperated by European political uncertainties. The combination of this week’s NFP report and next week’s BoC could help mark a turning point in USD/CAD, especially if NFP rebounds from last months dreadful headline and the BoC starts to sing a new tune. With USD/CAD trading near the top end of its recent range, we prefer to follow the momentum rather than fade the move at this stage and like buying dips below 1.30.”