Enjoy Loonie Power: Part II

With the Canadian dollar rocketing upward by 25% against the U.S. dollar since March, the benefits of foreign diversification are to be had with less gnashing of teeth. That is, if a long-term Canadian investor were to begin diversifying outside the country now, their U.S. assets will likely spend more time showing currency gains over the next few years; a short-term investor (horizon of up to three to five years), will more likely be in a position to take currency profits.

That’s because of the historical tendency of the U.S.-Canadian dollar exchange rate, which is to move between $0.70 (U.S.) and $1.05 (U.S.). When an investor buys near, or at, the historical upper boundary, the loonie will in all probability be trending back down sometime within the next few years. The flip side of this move, of course, is an upward trend in the U.S. dollar, i.e. U.S. assets held by Canadians will be basking in the glow of currency gains.

In addition to this historical tendency, there are several other factors to suggest putting more eggs in the U.S. basket as the loonie moves closer to its upper boundary:

• The loonie is presently overvalued by 20% according to the purchasing power parity doctrine

• Loonie strength has been fuelled by signs of a greater recovery in the Canadian economy but the soaring loonie is offsetting policy stimulus while the falling U.S. dollar is adding to U.S. stimulus — so relative growth rates should shift over time in favor of the U.S. and support the its currency

• The Bank of Canada hasn’t intervened in foreign exchange markets since 1998 but it and the federal government have been jawboning about the hazards of a high loonie for months, so the hands off policy on currency intervention could be reversed at some point, especially if the loonie surges past parity

• Unlike other past run-ups in the loonie, this one is occurring with a deficit in the trade balance and while inflation is diving below the Bank of Canada’s target rate, further suggesting that currency intervention could be applied to stop the loonie’s rise

• Intervention by the Bank of Canada can be carried out almost without limit since there are no operational constraints on printing domestic currency and buying up U.S. currency and government bonds (China has been doing this for years); this would definitely be a possibility should the economy begin to wilt under the weight of the loonie’s rise.

Comments

[bob adamson]

Mr. MacDonald’s article is timely. As he states, over the past 4 years the CAN$ has increased about 40% in comparison to the US$ (including about 25% since March of this year alone) and this accentuates the short term impact of the negative effects. These negative impacts are particularly noticeable in the Canadian export oriented manufacturing sector but are worrying to any producer or manufacturer whose production costs are paid in CAN$ but sales receipts are paid to them in US$ terms. In other words, it isn’t only the Canadian auto and auto parts manufactures and the like but also base and precious metal and the petroleum sectors etc. that are squeezed by these negative impacts; especially as they must adjust so quickly to these changes.

For these reasons it is doubtful whether the CAN$ will rise above parity with the US$ by an appreciable amount or for any sustained period over the next couple of years. Further, foreign investors shouldn’t count on future gains in Canadian equities being further compounded by currency appreciation because the Canadian economy can not function adequately in the near term if the CAN$ appreciates further.

Foreign observers are not sufficiently taking into account the possibility of quantitative easing by Canada's central bank because there appears to be relatively little internal need for this at present as Canada is coping internally quite well economically to date. Arguably there will be some softening in the internal economy as the CAN$ reaches parity with the US$ although this alone will not be the trigger for quantitative easing. Other factors could be this trigger though.

Canadian consumers and importers have benefited from the appreciation of the CAN$ and this reduces any remote risk of future domestic inflation thereby leaving the option of quantitative easing open to our central bank. Such easing would be very consistent with the central bank’s long standing policy of maintaining a ‘sticky float’ for the CAN$. The goal of this policy is twofold: (a) prevent disruption of Canada’s international trading position caused by too rapid or erratic changes in exchange rates and (b) maintain the freedom of the Canadian government and central bank to set internal monetary and fiscal policy to meet Canadian domestic requirements. Care has always been taken in following this ‘sticky float’ policy not to fall into the temptation of competitive devaluation which would only invite retaliation (a tit for tat situation that could only harm Canada’s international trade in the longer term as well as defeat the goal of that policy stated above). The stage is, however, set by current events for moderate intervention to slow CAN$ appreciation.

In short, Canadian consumers and importers are already enjoying the benefits from the appreciation of the CAN$ and would experience relatively little additional benefit from further appreciation in the short term. On the other hand, the point has been reached where further significant increase in the value of the CAN$ in the short term could have be particularly worrying for many industries and employees. In light of this, a rate increase by our central bank is not in the cards for the foreseeable future but quantitative easing may be.

2009 Oct 19 03:04 PM