All eyes were on the U.S. central bank this past week. And investors got what they were hoping for as the Federal Reserve reassured them that they have no plans to change policy any time soon. Nevertheless, bond markets continued to sell off, while parts of the equity market saw renewed pressure. The Canadian dollar sold off too, though it remains near a three-year high. We discuss this a bit more below and provide a brief update on the virus front.
The third wave of the global pandemic has continued its ascent over the past week in several countries. In Canada, the 7-day average rate of new daily infections stands at 3300, versus the 3000 from the week ago period. Ontario continues to drive nearly half of the country’s new infections, though Alberta and Manitoba saw the fastest rates of new infection growth over the past week.
Meanwhile, not much has changed elsewhere with parts of Europe imposing lockdowns once more as the rate of new infections has shown no sign of slowing. The same can be said for Turkey and India. And Brazil appears to be faring the worst of all, with its health care infrastructure under severe duress across the entire country.
The U.S. has yet to see any signs of a meaningful pickup in cases though it is worth noting the number of new daily infections is higher than it was in the week ago period.
All eyes on the “Fed”
The U.S. U.S. Federal Reserve meaningfully raised its economic growth projections for the year, lowered its unemployment forecasts, and modestly raised its expectations on inflation. With respect to the latter, the Fed reiterated its view that inflation will increase this year, likely above its target as the economy reopens, but then drift back down next year as things normalize.
The Fed’s commentary suggests it is currently planning no change to its approach to monetary policy, both with respect to asset purchases and interest rates. On the former, it indicated the rate of monthly bond purchases it has been making in an effort to increase the money supply and promote economic activity will remain in place until “substantial further progress” is made on its employment and inflation goals. It indicated it will try to telegraph well in advance when it expects to achieve these levels. On the interest rate front, its members indicated little probability of a hike in rates until late 2023.
The announcement from the Fed was largely in-line with what most investors had anticipated. But it seems to have done little to alleviate the market’s concerns that monetary policy may have to tighten sooner than planned in order to limit sustained inflationary pressures.
The Canadian dollar
Most investors have understandably been preoccupied with the recent volatility in bond markets, and the subsequent rotation witnessed across equity markets. As a result, the Canadian dollar strength has largely flown under the radar. But, it has quietly outperformed most other major currencies so far this year.
The rise this year has been notable because it has occurred in the midst of a relatively strong period for the U.S. dollar. This suggests that the Canadian dollar is being driven by domestic issues, as opposed to just broad U.S. currency weakness. These factors range from strengthening prices for commodities such as oil and base metals to increasing comfort that the elevated level of household debt won’t result in a major credit headwind in this country.
There is also growing anticipation that the Bank of Canada is more likely to slow its own pace of purchases of bonds, known as quantitative easing, before its U.S. counterpart. That may add further strength to Canadian bond yields, which in some cases (2-year and 5-year maturities for example) are already higher than in the U.S. In turn, these higher yields could make Canadian government bonds a more compelling alternative to U.S. government bonds for global investors, thereby providing some support to the Canadian dollar.
There is also the possibility that some of the competitiveness advantages the U.S. has enjoyed over Canada could fade in the coming years. This may be particularly true with respect to taxes as the U.S. is considering its first major tax hike since nearly thirty years, to partially fund some of the massive stimulus already undertaken and yet to be announced. It remains premature to assess the probabilities of this occurring at this juncture, but it could further support the Canadian dollar in coming years were it to materialize.
We expect some of the aforementioned tailwinds for the Canadian dollar to remain in place this year. While it presents a modest headwind to the performance of the U.S. and foreign investments we make in our portfolios when translated back to Canadian dollar terms, we believe it is a cost worth paying to ensure we manage a well-diversified portfolio.
Should you have any questions or concerns, please feel free to reach out.