Strong Currency Extends Bank of Canada’s Forecast for a Full Recovery

Yesterday, the Bank of Canada decided to maintain its exceptionally low interest rate of 0.25% and reiterated its commitment to hold rates this low until the end of the second quarter of 2010. This move stands in stark contrast to the rate increase implemented by Canada’s similarly resource-rich “G20 cousin” Australia just two weeks ago. In response, the Canadian dollar plunged 2% from the close the previous day.

Canada is not following in Australia’s footsteps even though it has declared the end of its recession:

A recovery in economic activity is…under way in Canada. This resumption of growth is supported by monetary and fiscal stimulus, increased household wealth, improving financial conditions, higher commodity prices, and stronger business and consumer confidence.

It appears that the strong Canadian dollar is preventing an early increase in rates. Such an increase could exacerbate the economic problems of having such a strong currency (up 15% so far this year) when the United States, Canada’s biggest trading partner (76% of Canada’s exports went to the U.S. in 2007 and 65% of imports came from the U.S.) is committed to maintaining near zero interest rates well into 2010. Indeed, the Bank of Canada specifically identified the strong currency as creating a lag in its growth forecasts and inflation targets:

…heightened volatility and persistent strength in the Canadian dollar are working to slow growth and subdue inflation pressures. The current strength in the dollar is expected, over time, to more than fully offset the favourable developments since July…The Bank now expects that the output gap will be closed in the third quarter of 2011, one quarter later than it had projected in July. Correspondingly, inflation is also expected to return to the 2 per cent target in the third quarter of 2011, one quarter later than in July’s projection.

Specifically, Canada cannot rely on expansion of exports to the United States for its recovery as long as its currency continues to rise against the U.S. dollar: “..the composition of aggregate demand will shift further towards final domestic demand and away from net exports.”

Given rates are already at rock-bottom levels, there is not much else the Canadians can do to attempt a depreciation of their currency. In fact, the on-going speculation amongst analysts and traders is that the Canadian dollar will eventually reach parity with the U.S. dollar sometime in 2010 (Barclays Capital) or as late as 2011 (Dennis Gartman of the Gartman Letter). While I am tempted to invest longer-term in the Canadian dollar given the outlook, I still find the Australian dollar a much better value given the 3.25% interest rate and a much lower dependency on economic conditions in the United States.

Be careful out there.

Full disclosure: long FXA

Comments

[Donald Ingram:]

There is a disconnect occuring throughout the world that started this past Spring and has gained momentum and volume going forward. The question is sink or swim. Remain with the US and sink or swim with the rest of the world. Looks like swimming is the only common sense choice, except for the UK who are still buying American debt. The remainder of the buyers have switched to short term purchases only. The US will increasingly find itself alone on an ocean of debt of their own making. Good luck.

Oct 21 11:26 AM

[bob adamson:]

A good assessment of the Canadian dollar situation Dr, Duru. The long standing policy of the Bank of Canada is to maintain a ‘sticky float’ for the Canadian dollar. The idea is to neither peg Canada’s dollar to that of the US nor let its exchange rate move without constraint day to day as markets dictate. Rather, the goal is to let the Canadian dollar find its market level smoothly over time and without undue day to day disruption for Canadian exporters and importers or intervention by speculators. The swing against the US dollar has been even wider that you indicate as the Canadian dollar has appreciated more than 20% from its low in March of this year but wild gyrations have been avoided during this rise. The float will therefore become stickier in the near future.

The Bank of Canada has indicated on several occasions recently that it will take further unspecified measures to further slow the increase now that parity with the US dollar is near. Significant further short term increases would have a major negative impact on many Canadian companies which have already absorbed a significant narrowing of profit margins (given that about 30% of Canadian GDP is based on international trade and that many corporations, including precious metal, base metal and oil and gas producers, have their production costs denominated in CAN$ and much of their sells receipts denominated in US$) prompting this position by the Bank

In short, Canada will avoid competitive devaluation and it appreciates that the US in the current economic situation must devalue its currency in a moderate and orderly fashion to manage its share of the debt bubble that created the instability that set the stage for the current economic crisis. On the other hand, Canada will be more vigourous in the foreseeable future in slowing the appreciation of the Canadian dollar.

Others have noted that New Zealand shares several of the current advantages to which Dr. Duru refers with reference to Australia (although the mining component of New Zealand’s economy is not as significant as in Australia).. Its dollar rather than that of Canada may be the next to rise significantly.

Oct 22 12:44 AM