Analysis - Canadian dollar rally seen stymied by struggling growth

TORONTO Tue Sep 18, 2012 8:26pm BST

TORONTO (Reuters) - Canada's dollar looks primed for a retreat in the coming days and weeks after powering to a 13-month high, with exhilaration over an aggressive U.S. Federal Reserve likely to give way to worries about slowing growth and risk of shocks from abroad.

Analysts said the country's record trade deficit, falling manufacturing sales and cooling housing market are harbingers of a softening economy that could quickly curb the enthusiasm of global investors who have flocked to the currency.

"You have to believe that the evidence - at least at this stage - is right now of Canada losing momentum. The trade sector, the numbers are looking particularly dismal," said Michael Gregory, senior economist at BMO Capital Markets.

"One would think that we would trade ... a little closer to parity before we take another run at C$0.95 and beyond."

The Canadian dollar rallied more than 8 percent from early June to hit C$0.9633 against the U.S. dollar, or $1.0381 on Friday, its strongest level since August, 2011.

The Fed's plan to pump $40 billion a month into its economy triggered the last leg of the rise, with traders betting the resulting U.S. growth and commodity price rise would boost Canadian exports.

The currency has also benefited from the European Central Bank's plan to tame the region's debt crisis, a hawkish Bank of Canada and a rising price for crude - a major Canadian export.

Canada is also one of a shrinking number of countries to maintain a coveted triple-A debt rating, giving its assets some safe-haven appeal.

RISKS FROM ABROAD

Yet many strategists believe the rally is overdone and not fully supported by fundamentals. The currency's strength has surprised many forecasters who had seen it holding near U.S. dollar parity over the next 12 months. <CAD/POLL>

"We've seen a one-way trade here since the beginning of June," said Don Mikolich, executive director, foreign exchange sales, at CIBC World Markets. "It would be natural to see some pullback."

He said the currency could ease back to a C$0.9850 to C$0.9960 range over the next month.

Some analysts said the soaring net long Canadian dollar position seen in Commodity Futures Trading Commission data suggests buying the currency is a "crowded trade" that could quickly reverse in the event of a shock.

"The risks are that we get something that unsettles the market once again," said Steve Butler, director of foreign exchange trading at Scotiabank.

While the ECB's plan to help struggling euro zone economies has tempered worries for now, analysts warily note that problems are bound to flare again. Meanwhile, soft Chinese data could also dampen demand for commodities.

And Canada would take a hit if a divided U.S. Congress fails to avoid the so-called "fiscal cliff" of automatic budget cuts that threatens to push the country back into a recession.

RISKS AT HOME

Soft U.S. demand and the soaring currency have already squeezed Canadian exporters by making their goods less competitive, contributing to July's record trade deficit and grim factory sales.

While the July trade data may be the result of one-off factors, the currency "is certainly getting to a point where it's somewhat painful because of the lacklustre performance in the U.S.," said David Watt, chief economist at HSBC Canada.

"You also have to keep in context that it's U.S. dollar weakness that's generally driving this right now, it's not necessarily Canadian dollar strength."

Bank of Canada Governor Mark Carney has talked about the challenges of the strong currency, but rejected the idea that the economy is suffering from so-called "Dutch disease", wherein high commodity prices increase the value of the currency and undercut the manufacturing sector.

The central bank has helped to lift the currency with language pointing to an eventual rate hike. But analysts said the signs of slowing growth and risk of getting too far ahead of the Federal Reserve have undermined that prospect.

"The Bank of Canada has remained the only central bank with a slightly hawkish bias. People are probably going to start questioning that a little bit more after the data that came out," said Greg Moore, FX Strategist at TD Securities.

Most Canadian primary dealers have recently pushed back their forecasts for the next Bank of Canada rate increase, which is not expected until at least late 2013, according to a Reuters poll. <CA/POLL>

To be sure, many currency strategists are still bullish about the Canadian dollar in the longer term. And given the recent volatility of currency markets, they said a near-term pullback is no sure thing.

"We've been surprised along the way here ... I don't want to underestimate it, it's been much stronger than one would've expected lately," said CIBC's Mikolich.

(Editing by Jeffrey Hodgson and Frank McGurty)