Why USD/CAD Could Rise Despite CPI

Based on the sharp decline in Canadian retail sales in the month of December, USD/CAD should be trading at a fresh 4 year high. Yet rather than extend its gains, the currency pair is currently below its pre-retail sales levels because consumer prices increased more than expected. While the rise in CPI reduces the chance of easing by the Bank of Canada, the 0.2% surprise should be easily overshadowed by the -1.4% disappointment in retail sales. Consumer spending dropped 1.8% at the end of the year, 4 times more than economists anticipated. Excluding autos, sales also fell 1.4%, which happens to be the largest decline in 5 years. The contraction in spending was broad based with consumers cutting their demand for furniture, electronics, building materials, clothing and sporting goods. As usual we can blame the weakness on Mother Nature as Eastern Canada was hit by a nasty winter storm that cut power to homes throughout the region. With a 1.8% drop in retail sales and a significant increase in the trade deficit at the end of the year, we are looking for a steep contraction in GDP growth in the month of December. The latest growth numbers from Canada are due for release next week and the data should confirm that Canadian growth slowed significantly in the last 3 months of the year.

While consumer spending is extremely important, it is clear that the market is placing greater weight on the increase in consumer prices. CPI was expected to rise 0.1% and instead increased 0.3% in January, pushing the annualized pace of growth to 1.5%, the highest level since June 2012. Core prices also rose 0.2% on a monthly basis and 1.4% annualized. The upside in CPI was small and year over year growth remains well within the Bank of Canada's 1-3% band. So why have investors become so excited about the report? The main reason is positioning.

The following chart of CFTC positioning shows how speculators were positioned last week. The data may be stale but given the continued rise in USD/CAD, we believe that speculators added to their short positions, which were already at historically high levels. When positioning is so heavily skewed in one direction, unambiguously positive data is needed to give speculators and investors the confidence to add to their heavy positions. With the market significantly long USD/CAD going into this week, every piece of economic data needed to be extremely weak to drive the currency pair even higher and unfortunately that was not the case this morning.

Inflation is an extremely important input into the central bank's rate decision and the rebound in price pressures after the decline in December will make the BoC more comfortable with the current level of monetary policy. Nonetheless, housing, trade and spending are still big problems and with the country only releasing December and early January data, we could still be looking at another month of weather related data disappointments before there is evidence that the economy has turned a corner. Lets not forget that Canada is heavily reliant on U.S. growth so aside from their own troubles, they will also be vulnerable to weaker U.S. demand at the start of the year. So while CPI has taken some steam out of USD/CAD's rally, we continue to believe that further gains are likely.