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

Includes: CUD, EWC, FXA, FXC
by: Duru

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