Canadian dollar under pressure over rates, economy

The Canadian dollar has had a sharp slide since the beginning of 2014 and most predictions are that it will go lower.

RBC economists say 87 cents by this fall, perhaps 85 cents next year, whileTD Bank says 85 cents before the end of the year, then a rebound to 90 cents in 2015.

On Friday the loonie closed up 0.26 of a cent at 89.21cents US, having dropped more than four cents since the beginning of the year.

• Canadian dollar tests new lows below 89 cents US

• How U.S. Fed chair Janet Yellen could affect Canadians

In the past week, the pressure on the loonie has been over interest rates and where theyll go in the U.S., compared to Canada.

U.S. Federal Reservechair Janet Yellen gave her first public press conference on Wednesday and gave markets a more precise description of when the U.S. central bank might be thinking of raising rates. Previously the bank had said a considerable period after it ends quantitative easing the practice of buying U.S. bonds to keep rates low.

But Yellen said that considerable period could be about six months or so, which could mean a hike in U.S. rates by mid-2015. Thats sooner than investors had expected and encouraged greater investment in U.S. assets, including its Treasury bills.

It also means the Fed has confidence that the U.S. economy will spring back this year.

• Loonie falls on Stephen Poloz's gloomy forecast for growth
• Bank of Canada lowers growth outlook as exports drag

Meanwhile, Bank of Canada governor Stephen Poloz is looking at a less dynamic economy and musing about lowering interest rates.

When you see Federal Reserve unwind thatQEprogram of bond purchases, probably toward the end of the year, thats going toput upward pressure on U.S. bonds, which is going to attract more capital to the U.S.- Scott Smith, Cambridge Mercantile Group

The global economy may not be just suffering through a hangover from the financial crisis," Poloz said in a speech to the Halifax Chamber of Commerce. "There are other, longer-term forces at work as well."

Those forces include a recovering U.S., a struggling China and some structural changes in the Canadian economy.

Its all intertwined. Theres been downward stress on the loonie as traders look to the U.S. bonds for higher yields, says Scott Smith, senior market analyst with the Cambridge Mercantile Group in Calgary.

Before Poloz took over in October, investors believed Canadas central bank would continue to be hawkish on ratesmeaning any change would be to higher rates, Smith says.

Exports didn't rebound in 2013

But as the Canadian dollar fell from parity last February to 94 cents US at the beginning of January, Canadian exports failed to recover as they usually do with a lower dollar. Canada's current account deficit keeps widening, a factor that usually pushes the currency down.

With the economy so lacklustre and unemployment still high, Poloz has to keep open the option of lower rates, Smith says.

Economic fundamentals drive bond prices and also drive Polozs outlook for the economy and what impact it might have on the currency, he says.

The strengthening U.S. economy also helps attract capital to the greenback and away from Canadian bonds, whose yields fall whenever the Fed announces a decision to taper its monthly bond-buying program. Interest rates are usually tied to bond yields.

And theres more such contrast between a stronger U.S. and a so-so Canadian economy to come, Smith said.

When you see Federal Reserve unwind that QE program of bond purchases, probably toward the end of the year, thats going toput upward pressure on U.S. bonds, which is going to attract more capital to the U.S., he said.

The structure of the Canadian economy has shifted in the past decade, away from an export-driven economy and toward a commodity-driven economy, Smith said. The rise of China, with its seemingly insatiable demand for commodities, has helped drive that change and it helped Canada weather the last five years with a better economy than most G8 nations.

But now, with Chinas economy faltering and the U.S. regaining its dominance, Canadian companies need time to shift gears.

Structural change in economy

The lower dollar is benefiting exporters of natural resources more than manufacturing exporters, according to Philip Cross, a former economic analyst with the Statistics Canada, who released a report about the loonie this week for the Fraser Institute.

This reflects how manufacturers adapted to the higher dollar over the past decade, he said. When the dollar was near parity with the U.S. greenback, firms hedged their exposure to the high dollar by reducing their reliance on exports and increasing their use of imported inputs.

This marks a structural change as companies relied more on the domestic economy, Cross said. It alsoaccounts, in part, for the failure of exports to rebound in response to the falling dollar.

Cross points to the shift in the Canadian economy since the 1990s, when a low dollar did power manufacturing exports. Since then, industries such as clothing, textiles and furniture have moved to low-wage jurisdictions such as China.

Cross argues companies face higher costs from a low dollaras they import equipment that can boost productivity or help them expand.

There is further weakness in the dollar ahead, perhaps enough to drive it as low as 85 cents US by the end of the year, according to RBC.

U.S. recovery will help Canada

But by then the U.S. will be recovering and there will be much greater demand for our products.

A weaker Canadian dollar enhances the competitiveness of Canadian goods in the U.S. market with a 10 per cent depreciation historically boosting export volumes by 3.3 per cent in the following two years, an RBC report said.

Smith believes the dollar will head back up as the U.S. hits its stride, because Canadian exports will bounce upwards.

As economic recovery picks up in the U.S., well see a spill-over effect where we will see it help our exports and we should actually see the loonie head up at the latter part of the year, he says.

But Canadian companies will have to make some adjustments in that period.

Were going to have to diversify away from the commodity sector, which helped us in the recession actually, and rebuild the export sector, which struggled with the downturn, he added.

Other economists believe the loonie will remain low well into 2014, chiefly because the U.S. is going to recover more quickly and will inevitably move to raise rates a step ahead of Canada.