It is very easy to just assume that the Canadian dollar (CAD) moves in direct response to U.S. monetary policy. The entire basket of currencies (which includes the CAD) that comprise the USD index has moved up sharply following the Fed’s rate hike earlier this month. However, there are several reasons to argue that the USD/CAD exchange rate is more influenced by the Canadian economic conditions than by US policies. In other words, we have a `` made in Canada`` exchange rate, so to speak.

The USD/CAD has been trading in the 1.30 – 1.35 range over the past six months, after hitting a hit point of 1.46 in January 2016. ( Chart 1).The 2017 forecasts range from 1.32 to 1.40. Forecasting exchange rates is fraught with high risks, and rather than going out on a limb, let us look at what are factors that will influence the direction of the CAD next year.

Chart 1 USD/CAD Exchange Rate

Let us look at the economic conditions that bear directly on the Canadian dollar.

• Economic Growth Continues to be Weak.As Chart 2 reveals GDP growth has consistently deteriorated over the past two years. In 2014, the economy grew at better than a 2.5 percent and was on a favorable recovery path of recovery. The collapse in oil prices, however, in latter part of 2014 hit the economy hard and growth-slump redound 1 per cent per annum since. In October of this year, GDP actually declined by 0.3 per cent in October. Manufacturing fell by 2 per cent, durable goods declined by 2.1 per cent and the overall inflation rate remained quite subdued at 1.2 per cent annually. While one month does not set a trend, the results do not bode well for the remainder of the quarter and for the hand off to 2017.

Chart 2 Canadian GDP Growth

• The Current Account Remains Negative. Canadian trade performance never recovered from the 2008 crisis. Prior to the collapse in oil prices, our trade sector reversed course and we continue to run a current account deficit of 3 per cent which operates as a major drag on overall economic growth.( Chart 3). Non-energy exports have been a major disappointment in filling the gap created by the loss of oil revenues since 2014.

Chart 3 Canada`s Current Account as a Per Cent of GDP

• Canadian Interest Rates Remain Low.  Currencies are influenced by the differential interest rates between two countries. The Canadian 5 yr bond yield – a good standard for comparison purposes— has been consistently lower than its US counterpart. (Chart4).

Chart 4 Canada –US5 yr Yield Spread

This differential is very much a reflection of slow growth and very low inflation in Canada.That is, the Canadian yield curve is "made in Canada". The Canadian yield curve moved up sharply, especially in the long end, in step with yields around the globe.However, the U.S.-Canada spread remains relatively constant along the curve. The Bank of Canada has made it quite clear that it does not look to raising the bank rate in 2017. The Bank is marching to the drum of the Canadian economy which remains out of step with that of the United States and Fed rate policy.