The Canadian dollar has been suffering from the doldrums recently after ranking among the strongest performers in the G 10 this year.
The loonie has dropped from the 80 s to 77 US cents, its lowest level since August because of the threat of Omicron, the new virus variant, a decline in commodity prices and the rise of the American dollar.
Adam Button, chief currency analyst at ForexLive, told Reuters that the Canadian dollar is treading in dangerous waters at the moment. The market is grappling with the increasing likelihood of lockdowns in China due to Omicron. BofA calculates that a 10% increase in WTI lowers USDCAD by about 1%, so if oil falls to US $60, the Canadian dollar could drop to 76.9 US cents. If WTI goes back to US $85, the loonie could potentially rise to 80 US cents.
BofA is optimistic about oil and expects a rebound in the new year. It said that our commodity strategists believe that WTI will average $82 bbl next year, which could serve as a terms-of-trade and structural flow tailwind.
Monetary policy expectations are a key influence on the G 10 currencies, and a hawkish Bank of Canada boosts the loonie. The BofA's rule for influence is that every 25 basis point hike by the Bank of Canada in excess of the U.S. Federal Reserve equals about a 20% increase in oil or a 10% increase in the S&P 500.
As of early this week, markets were betting on a March liftoff for the Bank of Canada with five to six hikes next year. BofA sees the first hike in April for a total of three hikes in 2022 and four in 2023. There are risks of a liftoff in January or more likely March, as the labor market has been absorbing slack fast, it said.
The Bank of Canada appeared more hawkish than the Fed until yesterday. In an abrupt policy pivot Wednesday, America s central bankers shifted to end their asset-buying program earlier in the day and signalled they expect three rate hikes next year.
The markets took this in stride, with investors betting that the Fed can pull off a soft landing, Bloomberg reports, and stock prices posted their biggest rally since 2020. The loonie rose to 78.26 US cents.
The BofA report, written before the Fed decision, delivers a similar forecast. It expects the Fed to stop tapering in March, lift rates in June and deliver three hikes in 2022, four in 2023, bringing rates to 2.25% by the first quarter of 2024.
The report said that the BoC is on track to lift rates in April if not earlier in the day, so it's likely that it's a source of USDCAD downside pressure.
BofA says there are risks to the forecast, and much of it is related to the virus.
A more severe outbreak could weaken commodity prices and cause a sour risk sentiment, both bad for the loonie.
Inflation could escalate further in the U.S., forcing the Fed to tighten more aggressively.