Wednesday, November 14, 2007

RBC reports that Canada's ever-rising dollar tempering export outlook

Canada's ever-rising dollar tempering export outlook...

We expect that domestic demand will remain firm, backed by the improvement in the terms of trade (as export prices continue to outperform import prices), recent tax cuts, the strong labour market and historically low interest rates. However, the continued deterioration in the U.S. housing market and the sky-high Canadian dollar are inflating the downside risks to the outlook for Canadian exports. Since October 16, the cut-off date for the Bank's


, the Canadian dollar has gained an additional 10% and touched its highest level in the postwar period at US$1.0826, well above the US$0.98 level assumed in the Bank's forecast.

...and will prompt Bank to lower overnight rate in early 2008

Canada's dollar is likely to remain elevated into early 2008, leading to softer demand for Canadian exports and resulting in the trade sector acting as a more significant drag on the pace of Canadian growth. The trade drag is likely to be greater than the Bank assumed in its October forecast, and we expect it will eventually prompt an easing in interest rates to offset this restraint. We expect the Bank to cut the overnight rate by 25 basis points in the first quarter of 2008 and have adjusted our forecast for Canadian interest rates downward accordingly.

We now expect Canadian interest rates to trade at the low end of their recent range, ending the year at 4.10% for two-year yields and 4.25% for 10-year yields.

In early 2008, the 25 basis-point cut in the overnight rate to 4.25% is likely to see short-term rates move modestly lower. Our expectation that the U.S. economy will reaccelerate in the second half of 2008 will likely see the U.S. dollar regain ground against its major trading partners, with the Canadian dollar likely to drift back down through parity. This will take some of the sting out of the trade sector's bite on Canadian growth and will give the Bank room to reverse its early 2008 rate cut.

We still expect interest rates in Canada to grind higher in the second half of 2008 but have trimmed back our forecast to 4.5% for two-year rates (from 5.00%) while maintaining our previous forecast of 5.05% 10-year rates at year-end. The two-year Canada-U.S. spread is forecast to narrow from +35 basis points at the end of 2007 to -35 basis points by the end of next year, with the 10-year Canada-U.S. spread holding in a range from -10 to -20 basis points.

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