George Davis:
Welcome to the August edition of the George Davis Report. Now, last month in our last update, we went over the reasoning behind the shift in our forecast profile for dollar Canada. And what we anticipated was an appreciation in dollar Canada through the balance of 2026, followed by depreciation in 2027.
Now, since that time, what we've seen is dollar Canada has peaked around the 1.4250 level and has returned back below the 1.4000 threshold. And so, what I thought I would do today is walk you through some of the underlying assumptions that we were making in terms of backing our forecast changes and assessing what's changed, what's remained the same, and what's changed since our last update.
So, one of the main things that was underlying the forecast change last month was that we were continuing to expect inflows into US assets. And that in turn, those inflows, those global inflows would help to prop up or lend support to the US dollar more broadly.
And as you can see in the chart on the screen, not only has the S&P 500 Index reached a new all-time high since then, but on a relative basis, US equities continue to outperform global equities on the whole. And so, that continues to suggest that we are seeing those inflows into the US asset classes that we were expecting. So, we haven’t really seen a big change around that dynamic. Secondly, one of the other things that we were expecting was we were looking for interest rate differentials between the US and Canada to remain relatively wide, and that in turn would also provide some underlying support to the US dollar. And, nothing’s really changed on that front. There’s been no changes to our expectations for the Fed or the Bank of Canada. So, in the US, we continue to expect the Fed to remain on hold with the Fed funds rate staying at 3.75% for the balance of this year as well as next year.
Here in Canada, we continue to expect the overnight rate to remain unchanged at 2.25% this year, with the Bank of Canada starting to raise interest rates in 2027. And that’s one of the main reasons why we think dollar Canada is going to depreciate, or move lower next year. The fact that with the Bank of Canada raising interest rates and the Fed remaining on hold, those rate differentials would narrow.
But in terms of this year with no change expected, that backstop or that underlying assumption in our forecast has remained the same.
Now, one area that has started to change a little bit has been the safe haven status of the US dollar. One of the things that we were seeing as we moved through May into June was we were seeing the US dollar act as a safe haven. So in other words, when US equity markets declined, the US dollar and dollar Canada would rally.
And so that provided an offset for Canadian investors in terms of their US investments: while the value of their US investments would go down as equity markets declined, that was partially offset by the accompanying rally in dollar Canada.
But one of the things you can see now in the chart on your screen is dollar Canada has started to return into the risk neutral category. And so, the big change there is what that suggests is if that type of risk neutrality persists, it could cause an increase in hedging behavior on behalf of Canadian investors. In other words, a little bit more of a pressing need to sell dollar Canada to offset some of their asset exposure in the US. So that’s been one important change that has introduced some downside risks and pushed dollar Canada lower.
Now, another assumption that’s been lingering in the background that we expect to continue, is on the trade side and the USMCA renegotiation. No agreement was reached by the July 1st deadline. And so the US and Canada continue to negotiate.
And we also have the threat of new tariffs coming into effect on August the 19th. And should that happen, what that suggests is it should nudge the average effective tariff rate for Canada higher. We’re currently somewhere between 3 to 4%. If those new targeted tariffs were to come into place, that would nudge the average effective tariff rate up towards something around 6 to 7%. So it would have a little bit of a negative impact there. But if you look at the bigger picture, under that scenario, roughly 80 to 85% of our exports going to the US would still be exempt under the current USMCA framework. And that would be a little bit lower, from roughly 85 to 90% where we’re at currently as of filming.
And so, that overhang or that background risk in terms of trade dynamics still remains in place. And at the margin potentially that could be a little bit more of a negative or bearish factor for the Canadian dollar, i.e. argue potentially for a higher move in dollar Canada over time. So that risk or underlying assumption hasn’t really changed either.
And then lastly, one of the new issues that’s come into play is twofold. Number one, we’ve seen joint Fed and Bank of Japan intervention to push dollar Yen lower, and that has caused the US dollar to weaken across the board.
And we’ve also had a little bit of a bruising of Fed credibility after the last FOMC meeting. And at that point in time, what happened was the Fed suggested that perhaps they would start to turn away from using PCE as a potential inflation benchmark. And what that does, is it injects more uncertainty into the marketplace in terms of what benchmarks the Fed’s going to use for inflation, what yardsticks are going to be in place in that respect.
And so from that perspective, that’s had a little bit more of a negative impact. That increase in uncertainty around policy has had a little bit more of a negative impact around the US dollar as well.
And so, I think when we look at things in terms of the US dollar losing its safe haven status and the Fed intervention and a little bit of a dent to Fed credibility, those have really been the two main catalysts that have changed over the past month and have helped move dollar Canada off of its highs near 1.4250, back below the 1.4000 threshold. And so, the big question is, do we think we can get back up towards those highs and potentially even higher as per our forecasts?
And I think one thing that’s useful to look at is a chart of dollar Canada. And the one thing you’ll notice here is if we start to return back below the 1.3930 level - and we’re just on the cusp of doing that right now - that would potentially suggest that we’re reverting back to that 1.3500 to 1.4000 trading range that we had been in from December of last year through June of this year. And so I think that’s an important yardstick to keep an eye on. If we do see dollar Canada moving back below the 1.3900 level, I think it would suggest that potentially we’re moving back toward a lower trading range. And perhaps, it would suggest that it’s going to be a little bit harder to get to the top end of our forecast, which is the 1.4400 to 1.4500 area as we go into year end.
And so if I had to reformulate the trading range for the month ahead, I think I would pitch 1.3700 on the downside and 1.4200 on the topside. And I think that what that would suggest for US dollar sellers is we were in a much more positive environment a month ago when we were trading up towards 1.4200/1.4250. I think in the current environment, if we were to see a bounce towards the 1.4100 level, I do think that that would likely present a new opportunity to reengage and cover some of your hedging requirements because the price action that we’ve seen of late, I think makes our 1.4500 forecast at the end of this year a little bit more challenging. And that’s something that we’re going to be paying more attention to in the weeks and months ahead. And we’ll reassess the backdrop and see if that necessitates any major changes to our forecast profile.
But right now, as I mentioned, I think 1.3700 on the downside to 1.4200 on the topside is what we’ll go with for the month ahead.
Now, stay tuned for our next update in September as we get through the summer months and start to move into the fall and we’ll reassess the economic backdrop, see what’s happening on the tariff front, see what’s happening to the US dollar as a safe haven, and see if that necessitates an additional change to our forecast profile.