By Peter G. Hall, Vice President and Chief Economist
After a biting winter, the birds are back, transiting to their nesting grounds. Loons will soon be on the lake, diving for dinner, and reappearing who knows where and when. An appropriate metaphor for the coin that these birds adorn. Right now, the legal tender loon has gone for a dive, and this variety can stay down for a long time. It has just plunged, and already pundits have concluded that it will remain low indefinitely, and many agree that it could go lower before heading up again. Are they right?
Here, context is key. Canada’s currency could do no wrong, it seemed, in the aftermath of the crisis. Glory-stories about our prudent fiscal management, our watchful and well-supervised banks, our abundant and sought-after natural resources and the surprising strength of our domestic economy drew a lot of attention worldwide. Hard on the heels of this publicity was money, in the form of portfolio and direct investments. These were further fueled by the huge influx of liquidity provided by quantitative easing, and its thirst for a decent (and safe) return. The post-crisis persistence of parity made it appear perpetual.
The plunge was a shock to most. Even so, the direction of movement was predictable. Hints that quantitative easing was almost over burst the false impressions it had created all over financial markets, including in commodities, currencies, risky bonds, and stock markets to name a few. We’re currently in the middle of a repricing phase, which has brought commodity prices hurtling to earth, and with it, our commodity-dependent currency. In the midst of the mayhem, most are wondering what is next.
To answer this question, we go to our 5-factor currency model. As commodity prices weigh heavily on the loonie, job one is to get a read on them. Our first factor is energy prices. When they correct, energy prices rarely remain at their lowest level. Currently that’s about US$40 per barrel, just above the trough seen in late 2008. Oil prices have recently moved up to the mid-to-upper $50 level, and we believe, based on global supply and demand conditions they will rise to the low-$60 level this year, and the low 70’s next year. This suggests some lift for the loon.
Non-energy commodities are also a Canadian currency driver. They haven’t been spared in the QE downdraft either, with metals leading the descent. Previously, we had believed that prices would hit bottom and turn around in 2016-17, but they fell faster than anticipated, and thus are expected to make a small although significant turnaround next year. Precious metals are another story, as we reckon they will still head downward. Agri-food prices are also predicted to move upward. Put it together, and this factor is also suggesting a somewhat higher loonie.
A long-held loonie-mover is interest rates. We track movements in the difference between Canada and U.S. 90-day T-bills as a gauge of our dollar’s direction. The January cut in Canadian rates by the Bank of Canada and rumours of a Fed hike have weighed on the currency, but we presume that markets have now factored expected future movements into dollar valuations. Some are guessing that Canada may be in for another rate cut, depending on how economic data does. We don’t believe that will be necessary, given the revival of non-energy exports, hence our sense that the loonie may get a boost when the move doesn’t happen – or if the Fed decides to delay.
Among these factors, we can’t ignore the U.S. dollar itself. It moves against all currencies in particular ways, and we are on the flipside of most of those moves. Given the U.S. economy’s leading role in this cycle, and the flight-to-quality that is expected in QE’s aftermath, this is actually a factor that will modestly mute the loon. Our final factor is related. Canada’s economic structure remains strong, and as such, in monetary tightening phase when risk re-pricing is the rage, the loonie is still bound to be an attractive safe-haven play. The ‘halo effect’ is still alive and well.
The bottom line? There are good reasons to believe that there is upside – however modest – for the Canadian dollar. Put these factors together, and we foresee it averaging US$0.82 this year and $0.84 next. Looks like a long dive, and that parity will soon be a distant memory.
This commentary is presented for informational purposes only. It is not intended to be a comprehensive or detailed statement on any subject and no representations or warranties, express or implied, are made as to its accuracy, timeliness or completeness. It is not intended to provide financial, legal, accounting or tax advice nor should it be relied upon. Neither EDC nor the author is liable for any loss or damage caused by any use of or any inaccuracies, errors or omissions.