Canadian dollar's respite from slide unlikely to last

By Leah Schnurr

(Reuters) - The Canadian dollar's respite from recent heavy selling will only be temporary as a sluggish domestic economy and a dovish central bank stance are expected to drag the currency lower, a Reuters poll released on Wednesday showed.

Investors dumped the currency at the beginning of the year, and it weakened substantially against the greenback in the first quarter.

The loonie touched a 4-1/2 year low nearly two weeks ago and although it has clawed back some ground since then, analysts say the bounce-back is likely near its limits.

The market will also watch next week's provincial election in Quebec, questioning whether the results will propel the province into a third referendum on separating from Canada.

The risk from the election could be short term, however, as opinion polls show the governing Parti Quebecois, which wants an independent Quebec, would lose if the election were held now.

Analysts were more bearish on the currency than they were in a Reuters poll just a month ago, forecasting it will drop to C$1.14 in a year, weaker than the C$1.13 that was forecast in March's poll.

"Fundamentally, we think the Canadian economy is lagging behind a little bit at the moment and that will be reflected in the exchange rate," said Shaun Osborne, chief currency strategist at TD Securities.

"We've been negative on the Canadian dollar for a while."

TD forecasts the loonie will drop to C$1.18 in three months before recovering somewhat to C$1.15 in six and 12 months.

After Canada's economy weathered the global economic crisis in relatively good shape, economic growth has been lackluster more recently as exports have failed to bounce back and businesses have held off on investing.

The country's hot housing market has also been a concern, with some economists predicting it will crash, though most expect it to cool gradually.

Earlier this year, the Bank of Canada said the strength of the Canadian dollar still posed an obstacle for exporters.

"We need to see a weaker Canadian dollar to facilitate the transition from domestic consumption-driven growth to more export-driven activity, just because of the tremendous loss in competitiveness we've seen in Canada over the last few years that really leaves us at a pretty significant disadvantage," Osborne said.

According to the median forecast in the Reuters poll of more than 40 analysts, the Canadian dollar will trade at C$1.11, or 90.09 U.S. cents, in a month from now.

That would be a slight weakening from the currency's Tuesday close, but it would be stronger than the 4-1/2 year low of C$1.1279 it hit in late March.

The poll sees loonie strength eroding from there, however, falling to C$1.12 in three months and to C$1.1250 in six months. In 12 months from now, the poll sees the Canadian dollar slumping to C$1.14.

The currency has been on a downward path since October of last year, when the Bank of Canada shifted its policy tone and dropped any mention of interest rate hikes on the horizon.

Monetary policy is expected to remain one of the major drivers of the Canadian dollar as the central bank has flagged its concern about the weak inflation environment and has left the door open to a rate cut if necessary.

"Certainly in their mind, a lot of the issues that (the Bank of Canada has) pointed out - persistently lower inflation, the lack of rotation of growth drivers toward the export sector - would all be helped by a lower currency," said Greg Moore, senior currency strategist at Royal Bank of Canada in Toronto.

"So I don't think they would stand in the way of it, which is why on a couple different occasions they've hinted that the currency may be more sustainable at lower levels."

The Bank of Canada's stance comes at the same time that the U.S. Federal Reserve is in the process of winding down its extraordinary economic stimulus program.

The possibility that the Fed could ultimately raise interest rates sooner than had been anticipated would support the U.S. dollar to the detriment of the loonie.

For now, that divergence between the two central banks has been priced into the market, which will likely drive sideways trade in the short term, Moore said.

Quebec will head to the polls on April 7. The leader of the governing separatist Parti Quebecois, Pauline Marois, said recently that Quebec citizens do not want a referendum on leaving Canada at the moment.

Quebec has had two referendums on whether to separate from Canada. Neither was successful, though the separatists lost the last one, in 1995, by just over 1 percentage point.

In the run-up to the 1995 referendum, the U.S. dollar-Canadian dollar pairing rose 3 percent but quickly retraced that once the result was clear, according to JP Morgan.

Similarly, in 1980, the pair gained 4 percent in the months before the ballot but reverted around the time of the vote.

(Polling by Sarbani Haldar and Siddharth Iyer in Bangalore; Editing by Peter Galloway)