- In spite of a strong Canadian economy and rising domestic interest rates, the Canadian dollar has been trading at a discount relative to its fundamental value largely due to trade risks.
- Our empirical work shows that over the last few years, non-fundamental or idiosyncratic factors are influencing the loonie to a greater degree. We estimate the downside impact of these factors, such as trade risks, to be on the order of about 2-3% currently. That magnitude is down from 5% in June.
- Typical fundamental drivers of CAD are also changing. We show that energy prices are playing a decreased role, whereas yield differentials are increasing in importance.
- While 78 U.S. cents remains our year-end forecast, we would not be surprised to see the loonie temporarily rally towards (or even) above 80 U.S. cents in the near term if trade talks between Canada and the U.S. are successful.
The Canadian dollar has been stuck between two conflicting themes. On one side, the economy has been running ahead of expectations, unemployment is below its natural rate, and inflation has increased to the central bank’s target. With this backdrop, the Bank of Canada has kept-up with the Fed in hiking its policy rate 100 bps in a year, providing support to the loonie’s nominal value. But, on the other side, Canada has a huge amount to lose when it comes to the U.S. Administration’s trade policies. We show that this trade-related uncertainty has been a dominant factor leaving the currency at a significant discount relative to where it would be trading otherwise (Chart 1). Needless to say that there is much at stake at this week’s NAFTA talks, where a successful outcome could send the loonie back to its equilibrium value of around 80-82 U.S. cents, at least temporarily.
Trade risk holding down the loonie
When looking at trade, the risk to the Canadian economy is greater than that of most major global economies. The U.S. makes up 49.4% of the trade-weighted Canadian dollar index. When Canada is facing a disproportionate economic threat from the U.S., the Canadian dollar adjusts accordingly. It just so happens that the other economies that have been in the tariff purview are also the next most important to Canada with respect to trade – China (13.1% of total), Europe (11.1%), and Mexico (8.5%). Since March 2018, the trade-weighted Canadian dollar has appreciated around 2%, but once you strip out the U.S. dollar from the index, the loonie has appreciated over 6%. We believe that this rally, which attests to Canada’s recent economic strength relative to most major economies, has left the Canadian dollar at or above fair-value versus the currencies of major trading partners, with the exception being the greenback.
The impact of policy uncertainty on the Canada-US exchange rate can be assessed quantitatively by comparing a standard estimation of fair versus the market value (Chart 2).1 The fundamental equation takes into consideration variables including yield differentials, energy prices, and non-energy commodity prices. From this, we can see that the Canadian dollar is presently about 2 to 3% undervalued, an improvement from undervaluation of 5% back in June 2018 and nearly 8% undervalued in May 2017. In Chart 2, we can see that the largest deviations from fundamentals tend to occur during times of high policy uncertainty.2
Non-fundamental or temporary factors often influence a currency’s value. This is certainly true for the Canadian dollar which has had numerous factors temporarily dominate price movements historically. In Chart 3, we show movements in the Canadian dollar that are not explained by model fundamentals (i.e., the equation residual). This demonstrates that over time, factors other than commodities and yield differentials can come to dictate pricing. Over the last few years, non-fundamental factors have increased in importance. As this is likely largely due to trade risk, if this threat diminishes, the market will focus more on fundamentals dynamics.
The evolving drivers of CAD
Just as trade and policy uncertainty can increase in importance for the Canadian dollar, even the fundamental drivers can be time variant. In a nutshell, Chart 4 reveals that the impact of energy prices on the Canadian dollar has declined while interest rate differentials have increased.3 This goes along with the Canadian economy’s recent transition towards less energy (and commodity) dependence. As this trend is not expected to reverse, it means that even greater focus will have to be given to central bank rate decisions and relative yield differentials. In this regard, the increase in Bank of Canada rate hike odds at its October fixed announcement has been a factor helping pull the loonie off its June lows of around 75 U.S. cents.
Still, the most important influence in the currency’s rise back to around 77 U.S. cents has been hopes for a successful trade agreement. If a deal is indeed struck, we would expect significant appreciation in the loonie and even a potential overshoot from the 80-82 U.S. cent equilibrium rate. If not, the trade discount would certainly increase and the loonie could retest the 75 U.S. cent level.
The main basis for the equation builds on empirical work conducted at the Bank of Canada over the past two decades that has examined the impact of commodity prices and interest rate differentials on the Canada-US exchange rate (Bank of Canada 1993, 2006, and 2008). Explanatory variables include the Bank of Canada’s energy and non-energy indices, Canada/U.S. yield differentials. Our estimation of the original BoC equation is as follows:
Please contact the author for estimation test results.
The Canada policy uncertainty index has statistical significance when added to our Canadian dollar model.
Using the single equations in Endnote 1, we estimate over rolling fixed windows of 2, 3, and 5 years and create a time series (monthly) of the coefficients and t-stats.
- Amano, Robert and Simon van Norden (1993), “Terms of Trade and Real Exchange Rates: The Canadian Evidence”, Bank of Canada Working Paper No. 93-3.
- Issa, Ramzi, Robert Lafrance, and John Murray (2006), “The Turning Black Tide: Energy Prices and the Canadian Dollar”, Bank of Canada Working Paper No. 2006-29.
- Maier, Philipp and Brian DePratto (2008), “The Canadian Dollar and Commodity Prices: Has the Relationship Changed over Time?”, Bank of Canada Discussion Paper 2008-15.
Written by Admin
Corporate executives are taking a dim view of their prospects, with a majority now expecting ...
Stock futures were little changed in overnight trading Tuesday ahead of a key inflation reading.Futures ...
Factories in China affected by Covid lockdowns can conditionally resume work, by housing workers on-site ...