Time to Buy the Canadian Dollar?

Includes: FXC, FXE, UUP
by: Hao Jin, CFA

The currency exchange rate changes every day based on various different factors, such as the employment rate, fiscal policy, trade surplus and interest rate, etc. During periods of financial crisis, Currency Shares ETFs became very volatile.

Currency Shares Euro Trust (NYSEARCA:FXE) is one of the most actively traded foreign currency ETFs. According to NationalFutures.com, it also adheres to technical signals. For the past decade, the euro has formed a bottom against the US dollar in the 3rd week in October, and then it has gone up for the remainder of the year and then sold off at the beginning of January. It has made a secondary low around the last week of March and then trended higher into the summer. Following that, the market has declined into October.

According to Barron's, the reason PowerShares' DB US Dollar Index Bullish (NYSEARCA:UUP) went up when this crisis began last September was because investors flew to safe-haven status. There was also another, more subtle reason for the dollar's strength. The unwinding of the debt bubble was equivalent to a short squeeze on the dollar. Borrowing dollars is effectively a short sale of the currency; when borrowers were forced to repay those debts as the bubble collapsed, they had to scramble to get their hands on dollars. The tightness in the money market was felt in the currency markets as well, sending the greenback higher.

From the macro point of view, Canada is in much better shape than US: employment rate of 8.5% is lower than US’s 9.5%; the Bank of Canada is not as aggressive as the U.S. Federal Reserve in promoting unconventional measure such as bond purchasing to boost the money supply; More importantly, Canada has commodities such as oil which emerging countries want.

Is it the right time to buy Currency Shares Canadian Dollar Trust (NYSE:FXC)?

I ran a single linear relationship between price of oil and Can/US exchange rate over the last 10 years (from January 4,1999 through July 7, 2009), and the regression is:

Exchange Rate = 0.5818 + 0.004 Oil Price

Daily exchange rate data is from Bank of Canada (source: Bank of Canada). Daily price of oil is from Department of Energy (source: Department of Energy).

The correlation is 0.9163, which means there is a very strong positive relationship between movements in oil prices and movements in the value of the Canadian dollar.

Based on the regression above we can calculate exchange: today’s oil price is $60. So 1 Canadian dollar should be 0.8218 US dollar. In other words, Canadian dollar is overpriced.

According to Big Mac theory (source: FxBigMac), 1 Canadian dollar should be 0.8695 US dollar.

According to interest rate parity theory (source: Wikipedia), the Canadian dollar is fairly priced because 10-year government bond rate are close enough for two countries.

Disclosure: I have position on FXC from time to time, but don’t have position at this moment.