Is The Canadian Dollar Overvalued?

by: Gary Dorsch

Morgan Stanley's Stephen Jen, Luca Bindelli, and Charles St.-Arnaud believe that the Canadian dollar is one of the more overvalued G10 currencies. They peg the March 2007 fair valuation of the USD/CAD at 1.22. Despite numerous CAD bulls in the market who quote the strong Canadian economy, optimism for continued strength in commodity prices and fears of energy shortages, Morgan Stanley believes the USD/CAD has bottomed because (in their words):

The BoC may now be sensitive to CAD strength. Exchange rates matter for commodity exporters, as we can see by looking at New Zealand. While we are not arguing that the strong CAD will push Canada into a recession, we believe that the impact of a strong CAD on Canada’s exports is meaningful.

When USD/CAD approached 1.10, the BoC may have been more concerned about the CAD than many realize. In fact, this concern was probably one important reason behind the latest change to the statement and its direct reference to CAD. We suspect that the BoC’s strategy could be to talk down the currency to remove some speculative pressure. Its signaling of a pause, in this light, does not seem surprising to us.

Furthermore, there has been a subtle but important shift in the underlying dynamics supporting CAD. In the past few years, commodity prices were strong and rising. This was supportive for Canada’s aggregate demand. However, more recently, support for the CAD has shifted to capital flows going into Canada. Whether CAD is supported by higher commodity prices or capital flows makes a big difference for monetary policy, in theory. ..

While the argument that the higher the commodity prices, the stronger the CAD should trade is correct, the market seems already to have an overly aggressive expectation on the future trajectory of non-energy commodity prices. It is far from clear that, as the US housing cycle soft lands, and central banks normalize rates, commodity prices will surge substantially higher. This is a judgment call, we concede.

See the full analysis.

On a related note, Gary Dorsch (Global Money Trends) submits: Bank of Canada Governor David Dodge said on Tuesday that the global economy in 2006 looks a bit stronger than the bank had anticipated and that there may be a need to increase interest rates further. At a media briefing in Toronto, Dodge told reporters that the bank's 2006 domestic inflation outlook published in January still looks appropriate, and that he sees core inflation just under 2 percent in 2006 and overall inflation just over 2 percent.

He said that recent wage increases in Canada were appropriate as productivity has also been increasing. He said he expects improved productivity through 2006 and 2007. Dodge also said that wage increases in the booming western provinces of Alberta and British Columbia didn't seem to be affecting wages elsewhere. The bank makes its next rate decision on April 25. The Toronto Stock Exchange's main index is pushing to fresh highs as metals prices prop up the resource-heavy market.

Canadian Dollar vs US$