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In a recent article published in the Toronto Star, a Canadian columnist outlined five reasons why the Canadian economy is in trouble.  Only a couple factors are unique to Canada, and several can be subsumed under the credit crunch, but the pessimists are sounding broad alarm bells. First on the list is the looming drop in prices for commodities, the cornerstone of Canada’s economy. Oil recently sank below $100/barrel, and gold dropped 5% in one day! In addition, China is threatening to curb demand in order to rein in inflation. 

The second and third causes for concern are a decline in bank credit and loss of confidence, respectively. Neither of these factors are endemic to Canada, as banks around the world have suddenly developed an aversion to risk and have tightened lending accordingly. Next, corporate expansion (namely of American companies) is stalling; Home Depot and Proctor & Gamble have already announced a temporary hold on opening new stores in Canada.  The final factor(s) are American consumers, which collectively spend $9 Trillion per year.  The recent tightening of wallets could spell massive trouble for Canada, since some of its provincial economies are primarily driven by cross-border sales to Americans.

In short, the Canadian economy could actually contract in 2008.  But perhaps the resulting decline in Canada’s currency, the loonie, would make Canadian exports comparatively more attractive and return the economy to firm footing in 2009.

MAR 25

Canadian GDP (MoM)(JAN) (12:30 GMT; 08:30 EST)
Expected: 0.4%
Previous: -0.7%

What Are The Markets Facing?

The Canadian economy has continued to remain resilient in the face of a U.S. and global slowdown, which the upcoming January GDP reading is expected to confirm. The monthly growth measurement is expected to have improved in January to 0.4% from -0.7% the month prior. Unlike other nations which are facing rising inflation and slowing growth, Canada saw inflation ease 0.2% and increases of 2.6% and 1.5% in wholesales and retail sales respectively. Additionally, the country can boast strong labor and housing markets, which was evidenced by unemployment falling to 5.8% and housing starts jumping 256.9K. Despite the culmination of all the positive fundamental data, which includes a widening trade surplus, many still expect the BoC to cut rates by 50 points at their next meeting. However, some are starting to call into question the pace of the cuts, feeling that the MPC may be moving too hastily in an attempt to match the Fed. The U.S., Canada’s main trading partner, has continued to show signs of entering a mild recession, which calls into question the sustainability of the country’s current growth. However, considering that the main culprit to economic weakness in the U.S. has been tight credit markets and a housing downturn, neither which have affected its neighbor to the north. If the Canadian economy can continue to sustain growth in the face of the weakening U.S., then Governor Carney and the MPC may start to reconsider their dovish bias, despite easing inflation giving them a free pass to cut rates.

Bonds - 10-Year Canadian Government Bond Futures

Canadian government bonds have consolidated as traders weigh the robust Canadian economy against the Impact of the U.S. slowdown. Additionally, as the quarter comes to end traders are reluctant to make moves as they get their books in order. Upcoming, GDP will give them something to trade off of as the report may tilt the balance in the debate of how resilient the Canadian economy.

FX - USD/CAD

The USD/CAD has continued to consolidate above the 200-Day SMA, as traders continue to look for signs that the Canadian economy is being impacted by the U.S. slowdown. The speculation that both the BoC and the Fed will cut rates by 50 points has left Loonie bulls and bears in a stalemate. There seems to be a general uncertainty surrounding the Canadian dollar as it has started to consolidate against most of the major currencies. The consensus is that the Canadian economy will ultimately be affected by the US slowdown, but until there are clearer signs the pair may remain in its current trading range. However, the loonie is starting to get support as commodity prices resume their record setting ways, with oil leading the way after the bombing of an Iraqi pipeline. Upcoming GDP will provide further insight into how long the economic fundamentals can remain strong. Any sign of softening in the economy may lead to the loonie depreciating, especially against the major crosses. A break above 1.02 may see the pair test resistance at 1.0370. If as expected the economy continues to demonstrate strength then Loonie bulls will look to bid the pair back under parity.

Equities - S&P/TSX Composite Index

The S&P/TSX is coming off of five days of gains as confidence grew that the financial crisis is dissipating. The benchmark has risen over 5% since March 19 as financials were the main beneficiaries of the easing fear. However, as concerns over the impact of the U.S. slowdown still lingers, the outlook for future earnings diminishes, and traders may look to start locking in profits. A clear doji candle may have signaled the end of the recent equities rally and epitomized the uncertainty that confounds traders. 13500 may prove to be a significant resistance level for the index as it failed to break it, for a second time. A stronger than expected GDP print will go along way toward continuing the markets recent bullish trend. However, weakening growth should flow through to stocks, as earnings expectations dwindle.

DailyFX

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The British pound extended its losses today, hitting an intraday low of 1.9883.

UK economic data was mixed with the GfK consumer confidence report and Nationwide house prices falling short of expectations. The current account did improve, but not enough to offset the bearish sentiment. The quarterly pace of GDP growth in the fourth quarter was unrevised, but the annualized pace of growth was lowered from 2.9 to 2.8 percent. Like the US, the UK economy is very vulnerable especially since consumer confidence hit a 15 year low. The Financial Times is also worried about the health of UK lenders. All three of the country’s largest banks hiked mortgage rates yesterday, putting further pressure on home

• Fate of EUR/USD Will Depend On Who Delivers the Bigger Surprises
• British Pound Extends Loses

US Dollar Could Fall to a New Record Low
We have seen some big moves in the currency market this past week, but these fluctuations should pale in comparison to the action that we expect to see next week. Not only are there a lot of economic data due for release from countries around the world, but Federal Reserve Chairman Ben Bernanke will also be testifying before the Joint Economic Committee. His comments as well as the ADP Employment report could set the tone for trading ahead of Friday’s non-farm payrolls report. We continue to call for further job losses in the US economy as Wall Street and Main Street announce more layoffs. With liquidity still a problem, we don’t expect any optimistic comments from Bernanke. For these reasons, the US dollar could fall to a new record low against the Euro in the coming week. The bearish outlook for the US economy is confirmed by the latest US economic numbers. Consumer confidence as measured by the University of Michigan fell to a 16 year low. Even though personal income ticked higher, spending was the weakest in 17 months. Regardless of whether the Federal Reserve admits it, 85 percent of the people surveyed by the University of Michigan already feel that the US economy is in a recession. They have cut back spending and are focusing on repaying debts and rebuilding their savings. Such a dramatic shift in sentiment will be difficult for the Federal Reserve to fix especially since banks and mortgage lenders have been counteracting the Federal Reserve’s efforts by tightening lending standards. Commodity prices are also skyrocketing with rice prices yesterday jumping 30 percent in one day. Inflation will come back to haunt the Federal Reserve, but with consumers retrenching and the housing market weakening, the outlook for growth is so bleak that the Fed may have no choice but to focus on fixing the more immediate problems. Although we think that the Federal Reserve will need to bring interest rates down to 1.50 percent, cutting interest rates alone will not do the trick.

Fate of EUR/USD Will Depend On Who Delivers the Bigger Surprises
The Euro has staged a dramatic recovery against the US dollar this past week and now it is trading approximately 100 pips away from its record highs. If economic data was the only thing that mattered, the EUR/USD stands a very good chance of breaking 1.60. German retail sales, unemployment and Eurozone PPI are the only major releases on the EZ economic calendar, which means that Bernanke’s comments and non-farm payrolls will probably drive the price action of the EUR/USD. However there is one potential European risk and that could turn the EUR/USD around, which is a major writedown by a German bank. This morning, Guenther Beckstein, the prime minister of Bavaria said that their state owned Bayern Landesbank will be announcing writedowns of EUR4bn, more than double their initial EUR1.9bn forecast. Although this number is small, it comes on the heels of a potentially huge loss for German banks. According to Spiegel, which is a leading German newspaper, local banks could “hemorrhage 70 billion Euros.” They are even speculating that Germany’s third largest bank, WestLB could require a 2 billion liquidity injection. Whether this happens remains to be seen, but whoever delivers the bigger surprises – the US or the Eurozone will determine the fate of the Euro.

Visit the Euro Currency Room for resources dedicated specifically to the Euro.       

British Pound Extends Loses
The British pound extended its losses today, hitting an intraday low of 1.9883. UK economic data was mixed with the GfK consumer confidence report and Nationwide house prices falling short of expectations. The current account did improve, but not enough to offset the bearish sentiment. The quarterly pace of GDP growth in the fourth quarter was unrevised, but the annualized pace of growth was lowered from 2.9 to 2.8 percent. Like the US, the UK economy is very vulnerable especially since consumer confidence hit a 15 year low. The Financial Times is also worried about the health of UK lenders. All three of the country’s largest banks hiked mortgage rates yesterday, putting further pressure on home owners. Next week, PMI numbers dominate the UK economic calendar.

Visit the British Pound Currency Room for resources dedicated specifically to the British Pound. 

Weaker Commodity Prices Drive Australian, New Zealand and Canadian Dollars Lower
The commodity currencies lost ground against the US dollar on the back of lower oil and gold prices. New Zealand’s GDP figures came in stronger than expected, with main contributors being rising dairy, petroleum and petroleum products exports. In spite of strong growth figures, fears of a slowdown continue to worry economists as the housing market continues to cool and businesses remain to be pessimistic. Next week’s releases should impact markets significantly, as business confidence coupled with ANZ commodity price, should help investors gain a perspective on the future performance of the business sector. Although no significant news was released for Australia and Canada today, upcoming releases promise to be a handful, with the Reserve Bank of Australia monetary policy meeting. Canada is set to release their GDP and unemployment figures.

 Tell us what you think on the Canadian dollar Forum. 

Yen Rallies as Risk Appetite Turns
The intraday turn in the Dow led to a similar reversal in the Japanese Yen crosses. Economic data from Japan last night was mixed with CPI rising by the fastest pace in 10 years, retail sales dropping less than expected and the unemployment rate rising for the first time in 4 months. Expect the Yen to remain in focus next week with a heavy economic calendar that includes Manufacturing PMI, Industrial Production, Labor Cash Earnings, and the Quarterly Tankan report. The strong Yen coupled with a global market slowdown is expected to take a toll on Japanese business confidence but even though this may impact the Yen, risk appetite is ultimately what matters.

Visit the Japanese Yen Currency Room for resources dedicated specifically to the Yen.

By Kathy Lien, Chief Strategist of DailyFX.com

Contact Kathy Lien about this article at klien@dailyfx.com