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Bullish on the Canadian Dollar

|Includes: SPDR Dow Jones Industrial Average ETF (DIA)

Recent events prove bullish for the Canadian Dollar.

Canada often struggles to be viewed with legitimacy on the world stage. Lacking the political, and arguably economic, clout of other countries, it is often seen as the ‘me too’ of developed nations. The same can be said for its currency. Having been nicknamed the ‘loonie’, and often compared to ‘monopoly money’ by Americans with derision, it is no surprise that some struggle to take it seriously. However, the recent strength of the Canadian dollar, and the very compelling case for its continued appreciation, have turned heads in the world of foreign exchange.

Since the start of June, USD/CAD (the number of Canadian dollars one must exchange for one US dollar) has fallen steadily. Having traded for 1.0489 June 1, it has since dropped to 1.0218 (a change of approximately 2.5%) as of June 18. With the USD/CAD's fall, questions are being raised as to whether there will be a strong run at parity between the two. On the other hand, many predict that another global dilemma, such as a continuation of the European sovereign debt crisis leading to another flight to safety, will send USD/CAD higher. However, recent events, notably a strong debt auction by the Spanish government and some of America’s biggest banks, seem to signal that fear in the market is subsiding, and the stage is set for a recovery.

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Bullish on the CAD

To understand fully the future path of the USD/CAD rate one must first look to oil prices, a key driver of the exchange rate. In order for the USD/CAD to continue its decline (i.e. the CAD strengthening), oil prices must continue to strengthen, and there must be continued investment in Canadian oil production by foreigners (namely the oil sands). It is hard not to be optimistic on both points.

Bull or bear on the near-term outlook, a medium to long-term case for the continued growth of emerging economies is indisputable. Real GDP is forecasted to grow at much faster rates in emerging economies than in the developed world. This case for growth was largely behind the run-up in oil prices pre-crisis, which saw prices nearing $140 per barrel; who is to say that once growth resumes, oil will not reach, or even exceed, previous highs? If oil prices climb, Canadian oil firms, which get paid for oil in US dollars, will sell even more US dollars than before to pay employees/taxes/dividends, pushing USD/CAD further down.

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Additionally, further investments in Canadian oil sands projects by multinational firms (i.e. Sinopec) will help the Canadian dollar. Such investments are becoming more and more attractive by the day, especially in the wake of the recent BP oil spill.  Offshore drilling in the United States (representing approximately 30% of US output) will face headwinds in coming years as a result of the expected regulatory backlash against offshore drilling; one only needs to look to President Obama’s recent ban on offshore drilling to see the early stages of this backlash. This ban has made investments in Canada more attractive because there is less political risk associated with investments in oil exploration and production. These investments, usually massive in scale, would lead to further appreciation of the Canadian dollar since foreigners must sell large amounts of foreign currency to acquire assets.

Rates

Looking at the interest rate picture of the United States vs. Canada going forward also proves bullish for the Canadian dollar. Bleak economic data, along with calls for restraints on government spending, show the difficultly in making a strong case for US interest rates going forward. The Federal Reserve’s commitment to maintainexceptionally low levels of the federal funds rate for an extended period” starkly contrasts the Bank of Canada’s most recent move. In a hawkish move, Mark Carney raised rates on the back of strong Canadian GDP data to stave off inflation. Despite recent jawboning by the BoC governor that “no particular path for monetary policy is preordained”, it is easier to imagine the Bank of Canada surprising markets by raising rates, rather than the US Federal Reserve changing its current stance. Such a move by the Bank of Canada, potentially at its next monetary policy decision, could help the Canadian dollar.

Reserve Currency

Although the recent media reports regarding the Canadian dollar as a reserve currency have been rather sensationalized (i.e. CBC’s headline of “Russia hoarding Canadian dollars”), there is some rationale behind them. The fuss was made after a BNP Paribas report stated that the loonie was in the “making of a reserve currency”. The stability of the Canadian banking system, coupled with a ‘credible’ (in terms of inflation fighting) central bank, and the relative stability of Canada politically, have led to the reserve currency comparisons. Despite this, the possibility of the Canadian dollar becoming a stand-alone reserve currency is slim. Canadian bond and stock markets are worth approximately 3.8 trillion USD; while the absolute figure is staggering, it represents a paltry 3% of the worldwide total. Currencies with a much higher proportion of the total, such as the US dollar (36%) and the Euro (29%), are more likely to act as reserve currencies. A more realistic alternative is the Canadian dollar being given a relatively strong weighting in a global currency unit, such as the SDR, going forward.

Risks

While the long-term case for the Canadian dollar is overwhelmingly bullish, there are numerous uncertainties. First and foremost, an economic double-dip would no doubt weigh heavily on equity markets. Given the strong inverse relationship since the beginning of the crisis between USD/CAD and the S&P 500, such a turn of events would almost undoubtedly lead the USD/CAD higher.

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Another potential risk surrounding the Canadian dollar is the upcoming G8 & G20 summit, hosted in Toronto and Huntsville respectively. While the summits in and of themselves are unlikely to produce a substantive shift in economic policy, there is always the chance that a ‘black swan’ type event will happen regarding security at the conferences. Given the already high tension surrounding North Korea on the geopolitical scene, a security breach at either of the summits, be it by anarchists or an organized group, could cause a brisk flight to safety.

With volatility seemingly passing in and out of the markets on a daily basis, it is hard to ascertain the near term trajectory of the Canadian dollar. A seemingly random continuation of the ‘risk off’ trade could spell trouble for the Canadian dollar in the near term. Gazing farther out, however, it is hard not to be bullish on the Canadian dollar. With oil prices, global growth, and the Canadian dollar taking on characteristics of a reserve currency, things are shaping up for a continued decline in the USD/CAD rate. The day where parity is reached may not be too far off. A continued period of time in which America’s beloved greenback is worth less than Canadian ‘monopoly money’ is likely. Coupled with the tail-end of the subprime crisis, it may even make Canadians look south of the border to pick up some real estate on the cheap. For Canadians with such ‘monopoly money’, one might suggest they take a look at such properties as Boardwalk and Park Place.

 

What do you think? Will, or will not, the loonie continue its upwards ascent?

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