CAD/USD: Will Negative Interest Rates Crush the Canadian Dollar?

CAD-USDThis Could Send the Canadian Dollar Plummeting

The Canadian dollar has plunged to a new 11-year low against the U.S. dollar recently. Since last Monday, the CAD to USD exchange rate has slipped from 0.7412 to 0.7291. That’s a 1.63% drop for quite a major currency pair! With oil prices hitting new lows and central bankers pursuing different policies in the two countries, the outlook for the CAD/USD pair is gloomy, to say the least.

Due to the significance of the natural resource sector to the Canadian economy, plunging oil prices are posing a serious threat to the nation’s entire economy. In fact, Canada’s economy is already in trouble. In the first quarter of 2015, real GDP in the Great White North shrunk 0.8%. In the second quarter, the contraction continued at a rate of 0.5%. Canada’s economy rebounded a little bit in July and August, at rates of 0.3% and 0.1%, respectively, before falling again at a substantial rate of 0.5% in September. (Source: “Gross Domestic Product by Industry, September 2015,” Statistics Canada, December 1, 2015.)

Negative Interest Rates Could Crush the Canadian Dollar?

Given the gruesome situation in Canada’s economy, Bank of Canada governor Stephen Poloz has assured Canadians that if the economy gets worse, the central bank is ready. Ready to do what? Well, he said that the Bank of Canada could consider negative interest rates in case of an economic crisis: “The bank is now confident that Canadian financial markets could also function in a negative interest rate environment,” said Poloz. (Source: “Negative Interest Rates an Option in Canada, Stephen Poloz Says,” CBC, December 8, 2015.)

In essence, negative interest rates mean the lender would pay the borrower for borrowing money. Right now, Canadian banks are getting paid on their deposits at the Bank of Canada. If the Bank of Canada were to go ahead and drop its interest rates below zero, Canadian banks would actually have to pay the central bank for their deposits.

So, why might the central bank adopt such a policy? Well, with recessionary pressure building up, the Bank of Canada wants the country’s commercial banks to loan their money out. By having negative interest rates on their deposits at the central bank, commercial banks would have more incentive to lend their money out and invest in the Canadian economy. And more investments could spark an increase of economic activity in the system.

Why the Loonie Could Hit New Lows Against the Dollar

Meanwhile, in the U.S., things couldn’t look more different on the monetary policy front. The U.S. Federal Reserve is considering raising interest rates for the first time since the Great Recession. Fed chairwoman Janet Yellen has said that she would like to see rates rise before the end of 2015, meaning there’s a decent chance that we are going to see a rate hike at this week’s Federal Open Market Committee (FOMC) meeting.

The underlying economy in the U.S. has also been doing much better compared to its neighbor to the north. In the third quarter of 2015, U.S. real GDP expanded at an annual rate of 2.1%, up from the initial estimate of 1.5%. In the second quarter, growth was at an even more impressive 3.9%. (Source: “News Release—Gross Domestic Product,” Bureau of Economic Analysis, last accessed December 14, 2015.)

What’s next? Well, keep in mind that at this point no one seems to know where oil prices will hit the floor. With the two countries’ economies heading toward divergent paths and their central bankers considering opposite policy tools, the Canadian dollar and the CAD to USD exchange rate could decline even further.

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