What's Ahead for the Canadian Dollar?

All the Stars Are Aligned

All the stars have recently lined up for the Canadian dollar. Crude oil prices surged to levels above those last seen late last summer during the hurricane season, with West Texas Intermediate breaking through US$70/barrel. Oil prices rose 11.0% between March and April. Natural gas prices also increased, but by a smaller amount. On the non-energy front, the Bank of Canada's commodity price index swelled 6.1% in April and a further 4.0% in early May. Gold and copper have been in the headlines as they reached new highs. Judging from commodity prices alone, the Canadian dollar could reach 95 U.S. cents in the coming period.

Financial markets' perception of monetary policy in Canada and the United States also spurred the loonie higher. The Bank of Canada's Monetary Policy Report sounded a hawkish tone, causing many analysts to revise higher interest rate guidance. In contrast, the U.S. Federal Reserve has signaled the possibility of an end to the past practice of consecutive rate hikes.

Meanwhile, the G-7 communiqué on April 21 weakened the greenback on a broad basis, even though finance ministers and central bank governors from the most industrialized countries pointed their fingers to China as where the bulk of the currency adjustment needs to take place. News and speculation of some central banks beginning to diversify their foreign exchange reserves away from the U.S. dollar further fuelled the negative sentiment. Sweden announced that it had reduced the U.S. dollar's share of its reserves from 37% to 20%, while boosting the euro's allocation.

Of What Type Is the Flight?

The Bank of Canada has become increasingly vocal about its views on the Canadian dollar. Last October, it revealed assumptions about the currency for the next two years. In April, they went even further and commented how much of a type-2 appreciation they would be willing to tolerate. In bank-speak, a type-2 movement in the currency is one that is unrelated to Canada's economic fundamentals. An appreciation of the loonie caused by a generalized depreciation of the U.S. dollar is a prime example. Such a move has few benefits to the economy, but many costs and, therefore, would require an offsetting loosening of monetary conditions.

The bank assumed the U.S. dollar would fall about 7% by the end of 2008, but that "only a small fraction of this…would be against the Canadian dollar." With the overnight rate in the 4% range, the Bank of Canada has plenty of ammunition to either reverse an untoward gain in the loonie or, failing that, to provide a sufficient offsetting stimulus to domestic demand.

There is also type-1 appreciation, however, in which fundamentals, such as commodity prices, drive the Canadian dollar higher. The bank views a type-1 appreciation as a net positive for Canada and would be expected to lean against it by tightening. The appreciation of the Canada/U.S. exchange rate over the past few weeks appears to be mostly of type 2, as the loonie fell slightly relative to the pound and the euro, while remaining little changed vis-à-vis the yen.

Risk of Parity

The next monetary policy announcement on May 24 is expected to dampen enthusiasm for the loonie. While Global Insight sides with the consensus call for a 0.25-percentage-point hike in the overnight rate, to 4.25%, we anticipate that the Bank of Canada will put a stronger emphasis on the fact that interest rates are in a neutral territory, and that it could go either way in the foreseeable future. It could even alert markets that the currency has traded above the bank's forecast, as it did in March. Meanwhile, we still anticipate the Fed will increase the federal funds rate one more time, to 5.25%, as insurance against inflation.

The relative bias in Canada-U.S. monetary policies, however, is contingent on economic outlooks for the two countries. For example, if the recent run-up in commodity prices were sustained, Canada would gain more income and wealth than anticipated from its natural resources and the bank would have to raise the policy rate further. This would only reinforce an appreciation of the Canadian dollar. In a different scenario, a downtrend in the U.S. dollar could become so persistent that interest rate cuts by the Bank of Canada would have minimal visible impact on the loonie.

Under these two scenarios, the Canadian dollar could break through parity with the U.S. dollar on a sustained basis. The odds of parity within the next few years have clearly risen in recent weeks, albeit they are still less than even. Canadians, however, can take heart in the fact that the country has already weathered a 40% appreciation since early 2003 quite well.