The Canadian dollar, or “loonie” as it’s called, has had a difficult time of late. Throughout 2011 it flirted with parity with its US peer, even closing at 1.059 USD on July 26 of that year. More recently it has traded down from parity but still strong, closing at 0.94 USD on July 1, 2014. But the past eight months have seen the loonie plummet in value. It closed at 0.7955 USD yesterday after surging 0.128 USD following Chair Yellen’s dovish statement on the pace of upcoming US interest rate hikes.
There are several macroeconomic forces at work in determining the loonie’s value. First and foremost is the overall health of the Canadian economy, and here is the source of much of the currency’s recent weakness. As a major producer and exporter of primary goods, the Canadian economy is highly sensitive to fluctuations in global commodity prices. Slowdowns in major markets such as India and China have seen global commodity prices tumble. The price of iron ore – a major Canadian export – nearly halved in the years from 2012-2015, and this is just one sampling of a broad trend across the commodity spectrum.
According to Glencore, one of the world’s biggest commodity trading companies, the trend is set to continue. It is predicting that global growth will remain tepid, and major commodities such as iron ore, oil, and food will see surpluses and downside price pressure through 2015.
Though, as Prime Minister Harper put it, “the oil industry isn’t remotely the entire Canadian economy,” it’s still a very big part of it. Oil accounts for 3% of Canada’s GDP and 14% of its total exports; it also employs around 94,000 workers (2012 figure). The precipitous drop in oil prices over the past six months is compounding Canada’s economic woes, with major oil producer like Talisman, Nexen, and ConocoPhillips recently announcing layoffs in their Canadian workforces. For a more in-depth look at Canada’s reeling oil sector, see Geopoliticalmonitor.com’s series Cheap Oil and Political Risk: Canada.
An ongoing commodity slump means slower growth for the Canadian economy, a belief reflected in a bout of recent growth projections. The OECD has slashed its growth outlook for Canada by 0.4% to 2.2% in 2015, and RBC Economics cut its 2015 forecast from 2.7% to 2.4% earlier in March.
The loonie’s value is tied to Canada’s relative position in terms of economic growth, interests rates, and (conspicuously absent of late) inflation vis-à-vis the United States. All of these determine whether the Canadian market is attractive to investors, and as outside money pours into the country it drives demand for the currency, increasing its value.
This helps explain the market’s reaction leading up to and following the US Federal Reserve’s meeting on Wednesday. The loonie tanked to new lows leading up to the meeting as investors bet that the Fed would react to US job numbers by increasing the pace of interest rate hikes. When Yellen indicated a slow pace, the Canadian dollar surged against the USD to close at 0.7955.
A widening spread between Canadian and US interest rates would drain investments from Canada as investors sought better returns south of the border.
The velocity of the Canadian dollar’s post-Fed comeback shows just how sensitive the currency is to a gap between US and Canadian interest rates. This again relates back to the state of the Canadian economy. The divergence in relative economic strength between Canada and the United States means Bank of Canada Governor Stephen Poloz is looking to cut interest rates to stimulate the economy just as Yellen seeks to hike them to keep the US economy from overheating. Complicating matters further for Poloz is Canada’s frothy housing market (which is anywhere from 20%-60% overvalued, depending who you ask) and record levels of household debt (the household debt-to-income ratio hit a record high of 163% in the third quarter of 2014). The Bank of Canada now seems poised to further reduce interest rates to boost the wider economy, though by doing so it risks expanding the real estate bubble – a bubble that will likely pop whenever rates are raised again.
This monetary tightrope restricts the Bank of Canada’s ability to keep pace with Fed rate increases, leaving the Canadian dollar vulnerable to further devaluation.
Current Account Balance
Canada’s current account balance has also been hit by falling oil prices, resulting in more downward pressure on the loonie. Canada reported a current account deficit of C$ 13.92 billion in the fourth quarter of 2014, up considerably from the C$ 9.60 billion deficit recorded in the third quarter.
There is another key determinant for the value of the Canadian dollar: the intangible whims of market sentiment. Here too the odds seem stacked against a rebound. Morgan Stanley projects the loonie will fall to 0.71 USD next year; the Royal Bank of Canada and Credit Suisse Group AG are forecasting 0.75 USD; and Macquarie Group Ltd sees it bottoming out at 0.69 USD.
Though there are those who see the loonie falling under 0.70 USD, most estimates are well off the currency’s 50-year low of 0.6179 USD in 2002.
In the words of a Bank of Montreal (BMO) report, the Canadian dollar will “remain in crash position” for the near-term. Downside economic pressures such low commodity prices can be mitigated by increased competitiveness from the Canadian manufacturing sector – but only partially. It will take a time to reverse the flight of Canadian manufacturers following a decade of a strong dollar, and the process of rebalancing has barely started. For example, the North American auto industry saw $10 billion in new investment in the United States, $7 billion in Mexico, and just $750 million in Canada through 2014.
Geopoliticalmonitor.com believes that, given the likelihood of a prolonged period of low oil prices, the Canadian dollar will trade at 0.72 USD by the end of 2015. However, the currency remains in “crash position” and faces considerable downside risk should the long-prophesized reckoning in Canada’s housing market finally come to pass.