Is the Canadian Dollar Undervalued?

As the price of oil increased from $54 in early 2007 to $95 in early November 2007, the Canadian dollar, as expected, moved steadily upward from 85 cents to slightly over par. This adjustment seemed smooth and consistent, a comfortable equilibrium. Since reaching par, however, the Canadian dollar has refused to follow the surging price of oil. WTI oil has increased from $95 in November 2007 to the $140 level in early July 2008. The Canadian dollar, which was slightly above par when oil was at $95 in November, has been slightly below par for most of the eight months since.

How and Why Do Oil Prices Affect the Canadian Dollar?

What factors could possibly explain why the Canadian dollar, which so faithfully followed the price of oil up from $34 in early 2003 to $95 in November 2007, has refused to budge upward since?

First, it must be emphasized that most economic relationships, and this particularly applies to the oil/Canadian dollar relationship, hold generally over time. Second, technically, and theoretically, economists expect a strong relationship, not between the price of oil and the Canadian dollar, but between the expected price of oil and the Canadian dollar. To be precise, we expect that, if the price of oil is expected to be higher than otherwise over a sustained period, this puts upward pressure on the Canadian dollar.

A possible reason why the Canadian dollar did not move above par as the price of oil zoomed up from $95 is that the rise in late 2007 was assumed to be a temporary spike. In November 2007, when oil hit $95 it was assumed the price of oil would fall quickly and steadily to the $73 level by year-end 2008. Instead, over the past eight months those early expectations of a quick retreat in oil prices have replaced by more robust forecasts.

What Are the Other Fundamental Determinants of the Canadian Dollar?

It must be emphasized that many factors can affect the Canadian dollar's value in U.S. cents. Short-term movements in the Canadian dollar are most heavily influenced by energy and other commodity export prices, the Canada/U.S. interest rate gap, and the view of international financial markets generally on the U.S. dollar. Over the longer term, the gap in Canada/U.S. inflation rates is an important determinant. In addition, many other economic and political factors have the potential to move the Canadian dollar significantly, and they sometimes do. That is why forecasting the Canadian dollar, or any other currency, is so difficult. The abovementioned factors, however, are those that have the most regular and most significant influence, as documented by years of economic modeling work at both Global Insight and the Bank of Canada.

Certain factors are most likely to be in a position to overwhelm the expected upward pressure on the Canadian dollar from a rising price of oil over the past eight months. First, if natural gas prices did not follow oil prices upward, that could explain why the Canadian dollar stayed flat as oil prices rose. However, over the November 2007–early July 2008 period, natural gas (Henry Hub US$) prices rose about 80% as WTI oil prices rose 50%. Thus, it was not the failure of natural gas prices to follow oil prices upward as they generally do. Second, of course the prices of non-energy exports is important. Overall, the prices of Canada's non-energy exports appreciated from November 2007 to early 2008, but have since receded to about their November 2007 level. Therefore, non-energy export prices have had a neutral impact on the Canadian dollar over the past eight months.

The other key factor in determining short-term movements of the Canadian dollar is the short-term Canada/U.S. interest rate gap—or, more precisely, expectations of this gap. This relationship has both theoretical as well as empirical support. These interest rates, and other rates related to them, influence short-term capital flows. The Canada/U.S. interest rate gap therefore provided some upward pressure on the Canadian dollar over early 2008, but at this point that has dissipated.

Conclusion

This review of the prime candidates that might be expected to explain why the Canadian dollar has not responded to the surging price of oil since last November has failed to identify any culprits. There are many possible explanations—political and/or economic, as is always the case with exchange rates. The most likely reason, however, is that the rise was originally expected to be temporary. Instead, oil price forecasts have been steadily and sharply revised upwards since last November and now Global Insight does not expect the price of oil to fall below $95 until 2012.

Thus, as is sometimes the case in empirical economic relationships, the response in the marketplace is taking a little longer than normal. With the price of oil recently being revised upwards, and the other fundamental determinants of the dollar either supporting appreciation or neutral, we believe the Canadian dollar, currently in the par range to the U.S. dollar, is undervalued.