Tuesday, April 6, 2010

Canadian dollar update -- caution warranted



The Canadian dollar has reached parity with the US once again. There's a lot going for it these days, and it shows, since the loonie is about as strong relative to the US dollar as it's ever been. That's the message of the first chart, which compares the spot price of the loonie (blue line) to my calculation of its purchasing power parity (green line). The gap between the two is pretty large, which suggests a significant "overvaluation" of the loonie.

The loonie has lots of fans because it is a "commodity currency" as the second chart shows. The loonie has traditionally been highly correlated to commodity prices, since Canada is a major producer of commodities. Commodity prices have been on a tear for over a year, and so has the loonie. Canada as a whole also looks pretty good relative to the US of late, since the country has largely avoided the banking crisis that the US is struggling with. (See this post which explains why: the Canadian government has for the most part avoided meddling in the housing and mortgage market.)

When the news is uniformly good, and the price of the beneficiary of the good news is historically high, that is the time to be cautious. Things might continue to improve, but then again they might not. At these levels, the loonie is very vulnerable to any news that is short of very good. It needs the good news to continue just to hold its current valuation. I'm not sure what might go wrong, but bad news has a tendency to come when you least expect it, and from a direction that nobody is watching. The loonie could go up some more, or it could hold at these levels for another year, and I wouldn't be surprised at all. But the risks are skewed to the downside in my opinion, so I would not want to be aggressively long the loonie.

Full disclosure: I have no exposure to the Canadian dollar at the time of this writing.

7 comments:

septizoniom said...

amazing: an unloved v.

John said...

I have a lot of Canadian friends (yes, I DO have friends) who visit the states regularly and they are very sensitive to the value of the loonie. Last year when the world as we know it was ending the angst was palpable amongst 'em. One good friend in particular was a little bitter about how undiciplined our fiscal policy was and we STILL had a strong currency. We had many enjoyable conversations on the currencies of our two countries. Today, as Scott's charts show, the tables have turned somewhat and this year my friend had a much more enjoyable trip. A strong loonie really improves the purchasing power of our Canadian neighbors when they come south for the winter.

I like to think the Canucks have played their fiscal and monetary policies well. As long as commodities like oil, gas, phosphates, timber, etc, are well priced the loonie will be fine. In fact, if we don't reign in our deficits fairly significantly in coming years, the loonie is one place I'm keeping an eye on to hide out.

John said...

Again, not mentioning any names, but there might be someone around that maybe should take a hint about 'broken record posts'.

septizoniom said...

the reign in spain falls mainly in the plane.

Benjamin said...

I gotta say, I am becoming a nut-job trying to understand currency. The Fed is "way too loose" and "exploding the money supply" ect etc etc.

Zimbawbwe here we come. Yes, I do not know how to spell that African nation.

But the dollar may rise in the future against the Loonie, even though Canada is following much more sober monetary and fiscal policies.

Abbot asked Costello, "Who's On First?"

"Who."

"That's what I am asking. Who?"

I ask, what does monetary policy mean in a globe with seamless borders, financially speaking?

And why will the Loonie go down if the dollar is cheapened by huge increases in supply?

What's on Second?

I Don't Know Is On Third.

You gotta be really old to enjoy this post, and maybe ot even then.

Scott Grannis said...

Benjamin: no one ever said that currencies were easy to understand. On the contrary, it's like three dimensional chess or worse. The value of one currency relative to another is a function of the supply and the demand for one currency and the supply and the demand for the other, all relative to each other. There are four independent variables at work, and guessing how they are going to move relative to each other is extraordinarily difficult. But I do think it's possible to have a decent idea about whether a currency is strong or weak relative to another on a PPP basis.

Benjamin said...

I don't care as long as you laugh at the routine, "Who's on First?"