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The second half of 2023 is "unlikely to be as good as H1" for the Canadian Dollar, says a major Canadian bank.

National Bank of Canada (NBC) says the Canadian Dollar, which was a mid-performer amongst the G10 majors in the first half of the year, will struggle over the coming months as the Bank of Canada will be keen to maintain a cautious approach to interest rates.

Furthermore, a global economic slowdown is anticipated to weigh on commodity prices, potentially denting Canada's terms of trade which could set the Canadian Dollar on a weaker path according to a monthly currency research update.

"The Canadian Dollar was the fifth best performing major currency against the USD in the first half of 2023. One of the main drivers of CAD appreciation in the first half of the year was the significant tightening of Canada-US interest rate differentials," says Stéfane Marion, an analyst at NBC's markets division.

However, now that inflation is trending down faster in Canada, NBC says it is very unlikely that the Bank of Canada will want to outpace the Federal Reserve on potential summer hikes.

This would weigh on Canadian bond yields relative to those of the U.S., potentially boosting USD/CAD. Elsewhere, the Bank of England and the European Central Bank are also expected to continue hiking, creating similar dynamics in GBP/CAD and EUR/CAD.

"In the absence of a boost from interest rates, the outlook for the Canadian Dollar will increasingly depend on commodity prices," says Marion.

NBC's economists expect global manufacturing activity to remain weak and they see a deterioration in Canada's terms of trade as a result.

This "should translate into a weaker loonie over the coming months," says Marion.

NBC's valuation model suggests the Canadian Dollar is now slightly overvalued, but looking ahead, analysts expect USD/CAD to return to the upper end of the 1.33-1.38 range in the second half of 2023 as the global economy shows tangible signs of weakness.

The Canadian Dollar is forecast to decline and open a route to 1.38 for USD/CAD by the end of the year, ahead of an extension to 1.40 by the end of the first quarter of 2024.

A recovery to 1.36 is anticipated by the end of the second quarter (current rate: 1.3268).

The Pound to Canadian Dollar exchange rate is forecast at 1.69 by year-end, 1.68 by the end of the first quarter and 1.68 by the end of the second quarter (current rate: 1.7154).

The Euro to Canadian Dollar exchange rate is forecast at 1.46, 1.46 and 1.47 for these respective time points (current rate: 1.46).