The Canadian Dollar: Boring is Good

Volatility in the currency markets this year has been high. The major currencies have fluctuated widely, racing in one direction, then turning, and racing in the other. All currencies have fluctuated similarly, that is, except the currency of our friendly neighbor north of the border. The Canadian dollar has maintained a consistent trend, one of strength (particularly versus the U.S. dollar), for most of the last two years, with minimal day-to-day or even week-to-week movements. In other words, it's been a boring currency…to trade as well as to watch.
 

However, what's been boring for those of us focused on the markets over a short time horizon — traders, speculators and spectators — has, in fact, been exciting for those focused on the markets over a long time horizon: investors. More often than not over the last two years investors have been very content to hold long positions in assets denominated in Canadian dollars: Canadian stocks (the energy, metals and financial sectors have been golden), Canadian bonds (also boring), or in just the currency itself. Of course, as we know, all good things must come to an end. Does the end of the strengthening trend of this truly boring currency draw nigh? Possibly, but not probably.
 

Over the last few weeks, the Canadian dollar did in fact sell off, albeit not all that much in terms of duration or distance. After reaching a high versus the dollar of CAD$0.9446 (or in Canadian dollar terms, $1.0586) at the end of April, it has weakened by nearly 4 percent. It reached a low (a U.S. dollar high) of CAD$0.9852 last Friday. That 406 pip move was the largest seen since last October, and has brought the currency back on the radar screens of traders and investors alike.
 

Before jumping to any conclusions and begin extrapolating this recent weakness into the future, let's go over the fundamental themes that have been driving the value of the currency over the last few years:
 

1. Strong economy – Canada's GDP growth in Q1 2011 was up 3.9 percent, well above market expectations. In fact, Canada's economy is set to perform better than that of any other rich country this year: unemployment is falling, leading indicators are rising, manufacturing is up (albeit off multi-year lows), and March's building permits figure showed the highest MoM increase since 2009!



2. Strong appetite for risk - The market has been embracing "risk on" trades since early 2009, following the financial market crisis. "Risk on" trades have typically included not only the buying of equities and commodities, but foreign currencies as well. Alternatively, "risk off" (aka risk aversion) trades would include the selling of the foreign currencies, which, as we know, the market has not yet embraced.



3. Balanced budget – Currency traders like to pick on countries with huge budget deficits (they short those countries' currencies); Canada's budget deficit of only 3.4 percent of GDP is one of the best of any major industrial country. As Bill Gross, manager of the world's biggest bond fund, put it in his latest monthly newsletter, "There will be attractive currencies regardless of risk appetite, call them 'value currencies' that should hold their value on a relative basis. He suggests those of Mexico, Brazil…and Canada, countries with good fiscal balance sheets." Canada's Finance Minister Jim Flaherty presents his budget on June 6 and he is expected to say that he will seek to eliminate Canada's budget deficit by 2014. 



4. High commodity prices – Speculators have been enjoying spectacular returns by buying commodities/raw materials and the currencies of those countries that produce them. That being said, prices of the Canada's key commodities this year actually have been falling: nickel (-6.6 percent), lumber (-36.0 percent),zinc (-8.2 percent), and uranium (-8.7 percent). Amazingly, only oil +12.5 percent, and natural gas +1.3 percent, have shown positive returns this year.



5. Tight central bank policy – The Bank of Canada was the first G-7 central bank to raise interest rates when it hiked its benchmark rate by 25 bps to 1.0 percent last year. And, with a strong domestic economy and a high and rising CPI (see # 8 below), the market forecasts that the BOC will hike rates by an additional 50-75 basis points by the end of the year! Typically, the currencies of those countries with tight monetary policies are very well bid.



6. High sovereign bond yields – Canadian government two-year bond yields of 1.53 percent are much higher than the U.S.'s 0.47 percent and the U.K.'s 0.93 percent, and slightly lower than Germany's 1.60 percent. In the credit default swap market, prices for Canadian government bonds reflect default risk so low that its five-year price is virtually negligible. Note that there are five AAA-rated sovereigns: the U.S., the U.K., France, Germany, and Canada. Only the U.S., however, has a negative "outlook."



7. Stable government – On May 2, Prime Minister Stephen Harper's Conservative Party won a majority in the general election after five years of minority government. He will now have the freedom to nudge the country further to right, which will include a strong pro-free-market agenda, lower sales and corporate taxes, avoiding climate change legislation, an agenda attractive to global investors.



8. Balance of trade – Periodically over the last several years, Canada has imported more than it exported, resulting in trade deficits. In fact, last July it reached the highest deficit since records began nearly forty years ago! As they do with the budget deficits, currency traders like to short the currencies of those countries with big trade deficits. Having said all that, Canada's BOT is back in the black this year, as you can see in the chart below.


Source: Bloomberg


9. Inflation - It is definitely rearing its ugly head in Canada. At 3.3 percent, Canada's CPI is nearing a two-year high. It is now higher than in the eurozone and the U.S., both at 2.7 percent.

The bottom line – stick with the trend 

We suggest you don't bet against the Canadian dollar…not yet, anyway. Despite the occasional disappointing economic statistic, there remain enough important fundamental trends to support the Canadian dollar for some time to come. The only caveat: a significant and secular change in the market's appetite for risk, from "risk on" to "risk off", would certainly reverse the trend in the Canadian dollar versus the U.S. dollar. However, giving its underlying strength, the reversal in trend for the currency would be much slower than for other foreign currencies. Watching it weaken, would be very boring indeed.