Where RBC sees the Canadian dollar heading next

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The strong Canadian dollar has been weighing heavily on U.S. dollar assets held by Canadian investors, but is the pain nearly over?

Here's one way to look at the issue: The S&P 500 is at a record high in U.S. dollar terms, but if you hold an S&P 500 index fund priced in U.S. dollars, then your holding in Canadian dollar terms is down more than 6 per cent since June. Your U.S. bonds are probably smarting even more.

Add in the lacklustre performance of Canadian stocks – the S&P/TSX composite index is down nearly 5 per cent since February – and your investment portfolio just might be sputtering as we approach the final quarter of 2017.

Currency trends are notoriously difficult to predict, but it helps to arm yourself with an understanding of what's driving the moves.

The loonie has recently surged above 82 cents (U.S.), up from about 75 cents since the start of the summer. The remarkably sharp increase follows surprisingly strong Canadian economic growth that has pushed the Bank of Canada to raise its key interest rate twice in the past three months – with more hikes likely on the way.

In a report on global currencies by Royal Bank of Canada, analysts now expect Canadian gross domestic product will rise 3.1 per cent in 2017, up from an earlier forecast of 2.6 per cent. Needless to say, they also expect the Bank of Canada will raise its key interest rate again in October.

This might suggest that the Canadian dollar is going to continue to move up, but RBC analysts believe that the biggest moves are behind us and that the loonie should settle back.

That's because the U.S. dollar, which has been weak against a basket of global currencies, is by no means down for the count: Stronger global currencies are merely adjusting to the fact that the U.S. Federal Reserve is not the only central bank now raising interest rates from ultra-low levels.

"The standard explanation for U.S.-dollar underperformance is that it reflects a reversal of the policy divergence theme that drove previous U.S.-dollar outperformance when the Fed was the only major central bank hiking rates. Now, the Bank of Canada has followed (twice) and markets are priced for varying degrees of policy normalization elsewhere, including the Bank of England, European Central Bank and smaller European countries," RBC said in its note.

Some observers believe that the U.S. Federal Reserve might even have to delay additional rate hikes given U.S. economic uncertainty, which is also undercutting the greenback. And confusion over the direction of the Trump administration isn't helping matters.

However, RBC expects that the U.S. economy will continue to power ahead (GDP in the second quarter was revised up to 3 per cent from 2.7 per cent), pushing interest rates higher.

"With just one hike priced between now and mid-2018, it should not be hard for the Fed to over-deliver," the RBC analysts said in their note.

Changes to U.S. tax laws, which could encourage U.S. companies to repatriate foreign earnings, could provide another bump to the U.S. dollar.

Yes, there are a lot of moving parts here, which underscores the difficulty in making currency predictions. Nonetheless, RBC expects the Canadian dollar will slip below 81 cents against the U.S. dollar in the fourth quarter of this year, and retreat below 79 cents in the first quarter of 2018.

Your U.S. dollar assets, which have struggled this year, might soon provide a tailwind to your results.