The winners and losers as the loonie keeps flying south

The Canadian dollar looks set to take a dive this summer, or at least to remain weak for some time to come.

Cyclical and structural factors point to Canadian rates falling earlier and faster than in the United States, meaning that now is the time to trim loonie exposure (although Government of Canada bonds do look appealing for domestic investors). That presents a risk to inflation, and consumers would feel it in the price of imported items — the Bank of Canada’s cut pacing may depend on the degree of pass-through from the exchange rate to consumers.

But rate moves always generate winners and losers, and a weak Canadian dollar would support exporters, could improve competitiveness and might help reverse the trend of declining net investment.

On both the activity and inflation fronts, the case for rate cuts has become much stronger in Canada than it is stateside. Real incomes are declining in Canada, real gross domestic product (GDP) growth is running at one per cent (versus more than 2.5 per cent in the U.S.), and elevated interest rates are weighing on investment and productivity.

Meanwhile, headline inflation is within the target band, and core measures are falling fast — in stark contrast to the “stall” in disinflation that U.S. investors are so worried about. What’s more, elevated shelter inflation measures, which governor Tiff Macklem loves highlighting as a reason for caution, will fall as soon as the Bank of Canada eases rates.

This all points to a widening of the negative spread between U.S. and Canadian rates. Currently, the yield on the two-year Government of Canada bond stands at 4.22 per cent, 47 basis points below the U.S. equivalent at 4.69 per cent. In the (extremely plausible) scenario that markets price in an extra 50 basis points of spreads (the equivalent of two additional cuts in Canada in the near term), the loonie would fall by around 10 per cent to $1.50 against the greenback from the current level around $1.35. That would mark the weakest level since 2003.

While that’s clearly not a good thing for anyone holding a long position on the loonie (now might be the time to trim exposure), and is an upside risk to aggregate inflation numbers (hurting import-reliant industries such as retailers), a weaker Canadian dollar is not all bad news.

A cheaper loonie would improve Canadian competitiveness and could contribute to Canada working its way out of its current productivity growth and investment slump. Progress on competitiveness is desperately needed. Canada fell to 15th place in 2023 from 8th place in 2020 in the International Institute for Management Development’s global competitiveness rankings, which are based on a comprehensive set of more than 300 efficiency indicators spanning the economy, trade, government, and infrastructure.

Probably the most telling chart on Canadian competitiveness at present is the index of Canadian unit labour costs in U.S. dollar terms (that is, what one unit of output costs an investor who measures returns in U.S. dollars). That index hit a record high in 2023 (or at least equalled its 2012 peak) and is currently 34 per cent higher than it was in 2016. In other words, building production facilities in Canada or including the country in regional or global supply chains has become a lot less attractive to global (and especially U.S.) firms and investors.

The rise in the dollar price of Canadian unit labour costs is mostly down to a sharp drop in productivity, especially in the goods-producing sector. That kind of structural deterioration demands an offset in the form of a weaker currency to correct for the lower output of Canadian workers. That’s why, in the short to medium term, a decline in the loonie could help the Canadian industry. Exports will benefit too, giving a direct boost to Canadian income.

A weaker Canadian dollar also provides a cheaper entry point for inward investment (and discourages the outward flow of Canadian capital), while making Canadian labour more affordable in U.S. dollar terms.

The only way to fix a productivity slump is through capital investment, which has been sorely lacking in Canada. Net direct investment (the inward flow of direct investment in Canada minus the outward flow of Canadian investment dollars) has become more and more negative over time; before the great financial crisis, the balance was positive. That trend needs to be reversed on both sides of the account, and the starting point is the competitiveness boost that a weaker Canadian dollar could deliver.

Bottom line: We have been arguing aggressively for the Bank of Canada to lead the major central banks in easing tight monetary policy. The effect this will have on the loonie is an important transmission channel to the real economy.

A weaker currency will come at the cost of some upside pressure on consumer prices (hopefully offset by falling shelter costs) and crimp retailer margins. But given the scale of the structural challenge faced by Canada’s goods-producing industry, a weak dollar is not a thing to automatically fear.