June 06, 2011
Posted by: Scott Petruska, CFA
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:
- 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!
- 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.
- 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
- 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.
- 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.
- 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."
- 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.
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.
- 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
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.
The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates. This material, including without limitation the statistical information herein, is provided for informational purposes only. The material is based in part upon information from third-party sources that we believe to be reliable, but which has not been independently verified by us and, as such, we do not represent that the information is accurate or complete. The information should not be viewed as tax, investment, legal or other advice nor is it to be relied on in making an investment or other decisions. You should obtain relevant and specific professional advice before making any investment decision. Nothing relating to the material should be construed as a solicitation or offer, or recommendation, to acquire or dispose of any investment or to engage in any other transaction.
Foreign exchange transactions can be highly risky, and losses may occur in short periods of time if there is an adverse movement of exchange rates. Exchange rates can be highly volatile and are impacted by numerous economic, political and social factors, as well as supply and demand and governmental intervention, control and adjustments. Investments in financial instruments carry significant risk, including the possible loss of the principal amount invested. Before entering any foreign exchange transaction, you should obtain advice from your own tax, financial, legal and other advisors, and only make investment decisions on the basis of your own objectives, experience and resources.
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The Canadian Dollar: Boring is GoodJune 06, 2011 Posted by: Scott Petruska, CFA
Volatility in the currency marketsthis year has been high. The major currencies have fluctuated widely, racing inone direction, then turning, and racing in the other. All currencies have fluctuatedsimilarly, that is, except the currency of our friendly neighbor north of theborder. The Canadian dollar has maintained a consistent trend, one of strength(particularly versus the U.S. dollar), for most of the last two years, withminimal day-to-day or even week-to-week movements. In other words, it's been aboring currency…to trade as well as to watch.
However, what's been boring forthose of us focused on the markets over a short time horizon — traders,speculators and spectators — has, in fact, been exciting for those focused onthe markets over a long time horizon: investors. More often than not over thelast two years investors have been very content to hold long positions inassets denominated in Canadian dollars: Canadian stocks (the energy, metals andfinancial sectors have been golden), Canadian bonds (also boring), or in just thecurrency itself. Of course, as we know, all good things must come to an end. Doesthe end of the strengthening trend of this truly boring currency...Read More