The strength of the Canadian dollar dominated currency markets throughout the third quarter of 2007 as solid economic growth as well as record oil prices drove the loonie to parity with the US dollar. The multi-decade event was heralded as the beginning of the end for the US currency, such claims are likely overblown, but the USDCAD downtrend is undeniable.
The North American currency pair spent much of July through August trading within a relatively narrow range. Yet many traders were subsequently surprised to see the currency break the key C$1.05 mark against the US dollar in early September and showing little hesitation in establishing 33-year highs shortly thereafter. Our latest positioning data shows that speculators fully expected the Canadian dollar to reverse course soon, but it is plainly evident that the broader forex market has other thoughts in mind.
[B]Interest Rate Differentials Favor Canadian Dollar Strength[/B]
The Canadian dollar rallied for much of the year on expectations that the Bank of Canada would raise interest rates several times throughout 2007. Above-target inflation forced the central authority to raise short term target rates to 4.50 percent—within 75 basis points of the US dollar’s then 5.25 percent rate. Yet a clear deterioration in financial market conditions had a significant effect on subsequent monetary policy tightening. Given a sharp rise in money market yields, current rate targets effectively translate into much more restrictive monetary conditions. In a speech to the Vancouver Board of Trade, Bank of Canada Governor David Dodge claimed that the tightening in money market rates took overall borrowing rates far beyond the bank’s short-term target—insinuating that further rate hikes would be unnecessary.
Given such a dynamic, traders no longer expect the Bank of Canada to raise policy targets through year-end. The Canadian dollar has maintained its stance against its US dollar however, as the Federal Reserve’s decision to cut borrowing costs immediately improved the loonie’s yield differential against the greenback.
Market yield curves show that traders expect the Bank of Canada to leave interest rates unchanged through 2007, but the US Federal Reserve is forecast to cut rates by 25 basis points through the same period. If rates move as planned, this would leave US and Canadian interest rates at parity for the first time since March, 2005. Such expectations have been one of the obvious causes of extended US dollar weakness. Given such a background, the USDCAD exchange rate will largely depend on the Fed’s next actions. This does not negate the Bank of Canada’s influence on the US-Canada yield spread, but the bank looks to stand pat in the face of strong commodity prices and robust domestic labor growth. Likewise significant, the Canadian dollar’s meteoric rise against the greenback poses significant risks to domestic export industries—a critical sector of the broader economy.
[B]Export Industries Begin to Feel the Pinch[/B]
There are advantages and disadvantages to having a strong currency. On the most fundamental level, a strong currency will boost Canadian imports but hurt exports. As a direct contributor to GDP growth, the immediate effect of a smaller trade surplus is to lower BoC’s long-term forecasts on overall expansion. Recent trade balance numbers have shown that surpluses have been on a relatively steady decline since peaking at C$5.9 billion in April. An unexpected improvement in August came as welcome relief to exporters, but a breakdown in the components shows that this came on a sudden drop in automobile imports from the US economy. The volatility of this measure implies that this may be a one-off event, with September data to potentially show an increase in auto import volume. Canada continues to boast a sizeable C$6.70 billion surplus with its southern neighbor, but a Canadian dollar at 31-year heights against the US dollar will only exacerbate the slowly shrinking trade surplus.
Canada remains the most trade-dependent country of the G8. The effects of a strong currency are undeniably negative for important sectors of the economy, but large multinational corporations have been actively hedging adverse currency risk through the forwards and options markets. This delays the full effect of the Canadian dollar’s movements for an extended period of time, but it remains clear that companies cannot fully mitigate currency risks over the long run. In low profit-margin industries, this can mean the difference between remaining afloat and shutting doors. Indeed, there have been several high-profile plant closings in domestic lumber industries that cite the strength of loonie as the primary factor of poor performance. Given that this weakness occurred within the context of strong commodity prices, it serves to note that the Canadian economy is still quite vulnerable to the overall performance of raw materials.
The benefit of a strong currency is that it boosts the purchasing power of Canadian citizens and Canadian companies. Given the height of the loonie, Canadian firms themselves are now seeking to diversify into other economies. A primary example of shifting investment interest lies in the banking sector, where Canadian conglomerate Toronto Dominion acquired US-based Commerce Bank for 8.5 billion Canadian dollars in October. Had the deal occurred just 6 months ago, the Canadian firm would have paid a substantial C$1.3 billion premium or 14 percent. Such an instance highlights one of the main reasons of why Canadian corporations may look to US companies for future deals. The net effect of shifting Mergers and Acquisitions trends and a shrinking trade balance may have a noteworthy effect on the economy and, by extension, the currency itself.
[B]Record Oil Prices Clearly Lend to loonie Gains, but Can they Continue to Do So?[/B]
Any detrimental effects of the surging Canadian dollar have been somewhat offset by a similar rally in global commodity prices, with record oil prices boosting demand for the loonie. It is interesting to note, however, that energy exports have actually declined through 2007. Such changes seem very counterintuitive at first glance, but we must remember that oil is globally priced in US dollars. Given the loonie’s march to parity, oil prices in Canadian dollars have actually remained below 2005 and 2006 peaks. The effect of US dollar tumbles are even more pronounced for Natural Gas, as Canadian producers currently receive just over C$7 per 10,000 BTU for the energy source. This is significantly below an average of above C$8 in the first half of 2007 and peaks of $10 in 2006.
The net effect of falling energy prices for the domestic producer is to decrease the significance of commodity markets on the Canadian dollar. This is clearly evidenced by the fact that the 50-day correlation between Crude oil futures and the loonie remains at its weakest since 2004.The pattern is similar for Natural Gas, cutting a key pillar of support for the domestic currency. Unless these commodity prices rally strongly in the fourth quarter of the year, it is fairly unlikely that they will lend support to the Canadian dollar.
[B]Canada Must Look Inward for Further Economic Expansion[/B]
Overall doubts on the future of export demand leave the outlook for domestic consumption critical to further economic expansion. A strong labor market has undoubtedly buoyed consumer spending, and Canadian dollar bulls certainly hope that this trend will continue through the medium term. The national unemployment rate set fresh 33-year lows through the month of September—a clear reminder that domestic firms continue to hire at an elevated pace. This in turn feeds strong consumption rates, as is evidenced by solid Retail Sales gains through the same period. Were it not for increasingly tight conditions in domestic lending markets, these factors would make a strong case for higher Bank of Canada Target Rates through year end. As it stands, the labor market will need to continue its robust growth to keep the economy expanding at its recent above-trend pace. Otherwise, an economic slowdown may threaten the Canadian dollar’s stance at multi-decade heights against the greenback.
[B]CAD Clearly Supported by Momentum, but How High Can it Really Go?[/B]
After asking ourselves whether the Canadian dollar could set parity against the US dollar, the next logical question becomes, “How high can we go from here?” The USDCAD currently trades at 31-year lows of 0.9800, with the loonie worth an impressive $1.02. Current economic fundamentals favor the Canadian dollar through the short term, and expectations of a narrowing yield spread between itself and the US dollar is single-handedly enough to keep the currency bid. Yet traders continue to ask themselves whether or not the Canadian currency can continue to outperform all G10 counterparts through end-of-year trade.
According to the Commodity Futures Trading Commission, the number of futures contracts long the Canadian dollar has reached record-heights through the month of September. This in and of itself does not signal the end of the rally, but it nonetheless suggests that the bulk of the currency’s medium-term advance is over. We cannot rule out Canadian dollar appreciation past C$0.97 against the US dollar, but it has become increasingly clear that the USDCAD may have a difficult time setting significantly new lows in the final quarter of 2007.
[B]Conclusion: The loonie May Gain Further, but not at the Same Rate[/B]
We believe that the Canadian dollar has little scope for a significant rally through the final months of the year. Increasingly overstretched positioning suggests that a subsequent unwind could lead to a violent USDCAD reversal., Record oil prices have clearly been instrumental in the currency’s advance to multi-decade heights, but the Canadian dollar’s strength has in fact limited the commodity’s potential for further gains. Given that oil and other energy commodity prices are priced in US dollars, the USDCAD tumble could reduce demand from countries like the US, although Chinese demand still remains robust. Other export industries are similarly affected, with manufacturing shipments feeling the pinch from increasingly expensive domestic goods. The one wildcard in the USDCAD equation remains the strength of the domestic consumer. If the labor market continues to create plentiful jobs, increased household spending may force the Bank of Canada to raise interest rates in a bid to cut off inflation. Otherwise markets will look to the US Federal Reserve to determine the future of the US dollar-Canadian dollar yield spread. Given the currency market’s continued emphasis on interest rate differentials, the USDCAD’s effective yield will likely be the deciding factor for subsequent price trends.
[B]USDCAD Technical Outlook[/B]
The USDCAD looks like it could chop lower before registering a significant low. Zooming in on the daily, it appears as though the decline from 1.1875 is in its 5th and final wave. The 5th wave began at 1.0866 and does have the potential continue lower but potential support is at monthly pivot support (.9695). On the intraday charts, the structure of the decline from 1.0866 looks like it is nearing completion as well. The indicator on the bottom of this chart is COT long commercial positions expressed as a percentage of total commercial positions. The commercial group is most bullish at the bottom and most bearish at the top (in this case, bullish/bearish with respect to CAD itself…so extremely bearish CAD correlates to bullish USDCAD). The percent long reading is at just 16% currently. The last readings this low were in January 2004 and October 2004. Both times, the USDCAD turned up and rallied for at least 10 figures (although the in the October example, the pair did not turn up until November). While lower prices are possible, chasing the pair lower at these levels is a dangerous proposition. A rally back to 1.0866, if only corrective, is not out of the question.
[B]Written by DailyFX Research Team[/B]