The Loonie’s speculative tailwinds

Written by Stephen Poloz

Global interest in the Canadian dollar has been riding high, fuelling speculation that it could break out into the 90-cent-plus range against the U.S. dollar. Speculation can be self-fulfilling, but during such episodes it is good to know what the currency’s fundamentals are, too.

Separating fundamental forces from speculative forces is very important. Speculative forces can be likened to a bird’s ability to fly, while fundamental forces are more like gravity. Birds can ignore gravity, but only temporarily — eventually, gravity prevails. When speculators as a group come to believe that a currency is very likely to rise, the very act of betting on that rise puts a flow of money into the marketplace that makes the speculation true. But if that takes the currency out of line with its fundamentals, the underlying forces of demand and supply eventually win out.

Which brings us to the recent behaviour of the Canadian dollar. The loonie reached a daily high of 88.4 U.S. cents on March 3 and, despite its recent retreat, is still forecast by many to keep edging higher in coming months. Many reasons are given for this, including prospects for higher commodity prices, rising interest rates, and even factors such as Canada’s fiscal and current account surpluses, neither of which typically appears in economists’ currency models.

According to EDC’s statistical model of the exchange rate, the dollar should be averaging between 85-86 cents at the moment. The dollar has fluctuated in a range between 85 and 88 cents during the first 10 weeks of the year, which is close enough to the model’s prediction. However, the more important issue is what comes next.

A year ago, the dollar was at about 82 cents and oil was about $50. Although oil prices today are well below their peaks of last autumn, they remain above $60, which is the key explanation for the 3-4 cent rise in the predicted value of the dollar during the past year. With world economic growth stabilizing and expected to moderate, energy and other commodity prices will probably ease further in the next few months. Interest rates may rise a bit more, in both Canada and the U.S., but if economic growth begins to moderate and inflation remains tame the pressure on interest rates to rise should dissipate as well. And, when the world economy grows more slowly, and credit conditions become less liquid, the U.S. dollar usually rises against most other currencies.

All this adds up to a forecast for the Canadian dollar in the later months of 2006 of 83-84 cents. If the price of oil were to fall by another $10 then the forecast value of the dollar would drift down to 80-81 cents. Of course, speculative forces are quite capable of taking the currency higher, even above 90 cents, before it heads lower in line with its fundamentals, but this analysis suggests that such a speculative episode would probably be short-lived.

The bottom line? Speculative juices almost always run rampant around global growth turning points, like the one we are seeing now, because economic growth becomes more divergent across countries. But once a moderation in world economic growth becomes apparent, the Canadian dollar’s fundamentals should reassert themselves and take the loonie lower.

March 9, 2006

The views expressed here are those of the author, and not necessarily of Export Development Canada.

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