Thursday, October 25, 2007

Market Watch: Canadian Dollar - October 2007

Is the high-flying loonie going to punish the Canadian Economy?

Six months ago I wrote an article warning the loonie (called this because of the bird on Canada’s one-dollar coin) was undervalued, oversold and due for a reversal in fortune. At the time the US dollar was worth 1.1850 against the Canadian dollar, with the euro valued at 1.56 Canadian. The Canadian economy was beginning to pick up following 6 months of lacklustre growth to the end of last year. Oil prices were rallying to over $60 having come off a low of $50 a barrel earlier in the year. Consumption was on the up, exports were growing steadily, employment was rising faster than forecast, business confidence was improving and there were some early signs that inflation was beginning to tick upwards. Against this backdrop of evidence it was a mystery why the currency was rejected, but that soon changed when economic report after report demanded the world take notice. Before we had time to blink the loonie had appreciated to 1.0850 against the US dollar by the end of May, at the time the Bank of Canada sat down to deliver their latest monetary policy assessment. When the Bank then signalled to markets that interest rates ‘may’ need to rise to keep inflation in check (interest rates were on hold for a year prior to this meeting), it helped catapult the loonie to new highs. Although the loonie was now up to a 1.04 to 1.07 price range against the US dollar, few experts believed it would ever reach parity with its US counterpart, with even fewer believing it could happen this year. At the beginning of 2007 most currency analysts and seasoned gurus predicted a price range for the pair of between 1.12 and 1.20 for the year. As of 12:00 EST on October 19, 2007, the US dollar was worth CAD0.9636. Hence the loonie has appreciated 18.84% since its low in February and in terms of the calendar year it has risen 17.34% against the US currency. This is a staggering level of currency appreciation in such a short time frame and while it may be celebrated by Canadians travelling abroad, it carries with it a very real set of economic challenges and dangers that could seriously derail Canada’s economy.

Firstly, let us look at the reasons why the Canadian dollar has appreciated in 2007:

1) Interest Rates: T
The principal driver for major currency movements is a shift in interest rate differentials. The Bank of Canada had largely been expected to keep interest rates unchanged at 4.25% this year, but in July the bank upped its lending rate by 25 basis points to 4.5%. The Bank has since moved to a neutral policy stance and rates are not expected to rise again for the foreseeable future. In the US the Fed, who were also expected to keep rates on hold throughout the year, actually cut rates by 50 basis points in September, to bring the key rate down to 4.75%. So currently, while interest rates are still higher in the US, the differential in rates between the two countries has narrowed by 0.75%. Markets have also priced in a further 25 basis point rate cut for the Fed before the end of the year, so in currency pricing terms the USD/CAD currency pair is trading on the assumption that by the end of this year both will have the same core interest rate of 4.5%. While this is the most important contributor to the loonie’s appreciation against the US dollar, it does not explain the level of appreciation we have had. Looking to the wider market, the interest rate differential between the euro area and the US this year has narrowed by 1.25% and during this time the euro has appreciated by 6.11% against the US dollar, compared to the 17.34% achieved by the loonie. Measuring currency appreciation purely on the movement in interest rate differentials, we might have expected the loonie to have appreciated by 4.9% against the US dollar (using the euro as the base denominator). But this is 12.44% less than the actual appreciation seen. We must also note that in terms of interest rate outlook, the European Central Bank is leaning to the upside on future rates, while the Bank of Canada is ‘tilting’ to the downside. Thus, if currencies are moving on interest rate differentials alone, the euro should be performing much better than the Canadian dollar. Yet the Canadian dollar is today worth 10.7% more than euro than it was back on January 1st. So is the real value of the loonie USD1.1087 and should the euro be worth CAD1.54 rather than the CAD1.38 we have today?

2) Oil Prices
It is a well established fact that the Canadian dollar often follows the movement of oil prices. The correlation is difficult to understand in the sense that while crude oil is an important export component, it only constituted 8% of total exports from Canada to the end of August 2007. An even more surprising stat is that in constant dollars, crude export revenues only rose 1.3% thus far in 2007, lagging the increase in total exports, which are running 1.8% higher than the same period in 2006. Oil prices have risen from a low of $50 in January to a high of $90 (Oct 19). The fluctuation in oil prices is volatile and what we can clearly ascertain is that Canadian oil companies have been unable to reap the full rewards because oil proceeds (denominated in US dollars) are converting into a smaller number of Canadian dollars than they used to. By the way this goes for all other US dollar-denominated commodities also, most of which have not experienced anything near the level of price inflation seen in oil. In terms of the increase in overall Canadian exports in 2007, crude is only responsible for 3.7% of the total increase. In the case of Canada, oil is only an 8% component of all exports and has contributed a mere 3.7% to the year over year gain in all exports in 2007. Therefore oil is something of a misnomer as far as the loonie is concerned and oil on its own should never be used for determining what the loonie exchange rate should look like. Will someone please notify those misinformed speculators?

3) GDP
Canadian GDP has been very robust in 2007, the economy coming off a rather lethargic performance in the second half of 2006, when it grew at annualised rates of 1.3% and 1.5% respectively in the final two quarters. Canada grew by an impressive annual rate of 3.9% in quarter one 2007 and a moderately slower 3.4% in quarter 2. This compares very favourably with annualised growth rates of 0.6% and 3.8% in the US for quarters one and two in 2007. While Canada’s GDP rates seem high this year they fall well short of the levels of growth regularly seen in Asia and many of those countries have their currencies pegged to the US dollar, so they have grown spectacularly with little or no currency appreciation - China has grown at annualised rates of over 11% in the first 3 quarters of this year and its currency has moved only marginally. A fairer comparison for Canada might be to look at the GDP rates for the euro area and the UK. The 13-nation euro area has grown at annualised rates of 3.2% and 2.5% in quarters 1 and 2 while the UK has grown at rates of 3.0% and 3.1%. While growth was more robust in Canada than in Europe, the Bank of Canada raised interest rates by just 25 basis points this year, as against 50 basis points by the ECB and 75 basis points by the Bank of England. We can however make the assumption that the strengthening loonie was instrumental in keeping inflation at levels that meant the Bank of Canada only had to raise rates once this year. We can deduct that Canada’s growth in 2007 is on average 29% greater than that in the euro area in the first half of this year. If we use growth as a means of determining currency value and use the euro as our base measure we see the euro has strengthened 6.11% against the US dollar so far in 2007 and if we factor in the growth differential for the Canadian economy, it means that using this calculation the loonie should have appreciated 7.88% against the US dollar (6.11% * 1.29). The loonie has in fact gained 17.34% in this time, so one could argue that 9.46% of the loonie’s appreciation in 2007 cannot be explained by underlying economic fundamentals, when we take growth as the factor behind currency appreciation. Therefore the loonie should be trading at USD1.0739 and not at the USD0.9650 price it is currently at.

The Predicament

All bull runs must come to an end some time, surely. The start of the current loonie bull trend can be traced back to January 2002, when the US dollar was worth CAD1.60. There is also a precedent for the sharpness in the loonie’s appreciation – back in 2003 the loonie rallied by 21% over the year before a 5% correction in the first 5 months of 2004. The economic circumstances were different back then as the Canadian dollar was still cheap in US dollar terms, meaning Canada was still competitive internationally and the US and global economies were expanding at an increasing rate. Today we have a slowing US economy and a global economy that has started to stutter, so it is now a seismic challenge for Canadian companies to be competitive internationally at an uncertain time when the US dollar is cheaper than the Canadian dollar. At the very least, Canadian companies will need time to adjust and for this to happen the currency has to stabilise soon, or Canada’s economy is destined for a hard landing.

How might the loonie bull be brought down?

1) Deterioration in Economic Data
It is only a matter of time before the sharp appreciation in the currency begins to weigh heavily on the domestic economy. The first signs of strain will be seen in Canada’s trade data, as cheaper imports and more expensive exports should take their toll on the country’s heretofore impressive trade surplus, in particular with the US. The decline in manufacturing shipments will intensify as US consumers shy away from buying ‘more expensive’ Canadian products and Canadian consumers themselves travel south of the border for cheaper American cars and other large durable goods. Employment will soften as Canadian companies lay off people because the company is unable to compete or because of reduced order intakes owing to a US slowdown. Corporate profits will tumble as companies that export their products and services see their revenues plummet because of the poor exchange rate. GDP numbers will decline as an export-dependent economy struggles with productivity and competition. Once disappointing data begins to regularly hit the newswires, speculators and investors alike will ditch the currency and the loonie will gradually depreciate. However, because of the significant time lag between the here and now and when economic reports become available, the drip feed may be too slow to prevent a sharp economic slowdown.

2) Bank of Canada intervention
If the Bank of Canada is seriously concerned today about the outlook of a 96 US cent economy over the next year, then they could cut interest rates which would lead to sell-off and result in a significant depreciation in the loonie. The Bank of Canada do not have sufficient foreign exchange funds to influence the loonie’s value through direct market intervention and in any event such an exercise would prove futile, as demonstrated by the failed intervention we witnessed this summer from the Reserve Bank of New Zealand. The Bank of Canada should at the very least up their concerned rhetoric in public, to signal a determination to face down currency speculators, who we can argue are responsible for more than half of the currency’s appreciation in 2007.

3) Financial Market Stresses
If we get a prolonged period of deterioration in global financial markets, traders and investors alike will be forced to reassess risk and outlook for the wider global economy. Speculators poured into the loonie this year upon the belief that the Canadian economy could withstand a US slowdown – the theory being Canada is a commodity rich country and a booming world economy demands more commodities and a commodity currency could only go up. When markets finally come to their senses and accept a downgrading of the global economic outlook, then commodity prices should drop, as should appetite for commodity currencies like the loonie. In this situation existing speculators will liquidate their Canadian dollar currency positions and the loonie will depreciate to a more realistic value level. How quickly it happens will depend on the trigger for the liquidation event, but it may not be orderly and the loonie could fall very sharply.

4) US Recession
If the US economy should find itself officially in recession (GDP contracts), then it is highly unlikely that Canada will get off scot-free because the ‘guilt by association’ syndrome is bound to stick. The loonie will come under persistent pressure, not just because our speculator friends run for the exits, but also because a recession scenario will create a new wave of Canadian dollar selling by funds and investors, who see the loonie in a completely different light.

It could be 6 months before I delve into such detail on this subject again and if I am to make a forecast now I guess my view is that the US dollar will very soon bottom out against the loonie and by April 2008 the greenback will have risen to be trading in a range of 1.07 to 1.11 once again. I also believe economic performance will suffer in Canada over the next half year with productivity failing to keep pace with the rising competitive challenge of a grossly inflated currency and the Bank of Canada will be forced to move, to cut interest rates by at least 50 basis points within the next 6 months.

Ted B'Struck - October 25, 2007


Pierre said...

I agree with the view taken. Cut rates now!

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