In a summer where everyone’s focus has been on inflation, interest rates and stock market volatility, there has been less attention on the Canadian dollar and government deficits. I will deal with the latter down the road, though the information coming out of the US suggests that there has been some improvement on the fiscal side. The Canuck buck, on the other hand, has not been going in the right direction this year. That is having implications for everything from inflation to travel plans.

 

This week has actually been one of the better ones for the Loonie in weeks. We saw a bounce from a low of around 76.25 US cents last Thursday to the 77.7 cent area going into today’s session. That close last Thursday, however, was the worst we’ve seen since November 2020 and represented a drop of over 3% from the start of the year and more than 8% from the peak of 83 cents in June of last year. With the rally this week, the Canadian dollar is off about 2% versus the greenback this year, but that is the best performance of the G10 currency baskets. The Japanese yen, British pound, Norwegian Kroner, the Swedish Krona, Danish Krone and Euro are all down more than 10% this year.  This modest decline, if it held for the rest of the year, would also be one of the smallest retreats for the Loonie since back in 2011.

 

 

You will all remember 2018, when signs of economic weakness amidst tighter policy and US trade wars with everyone from China to Canada, caused the Canadian dollar to sink almost 8%. The worst patch in recent memory was from 2013 to 2015, when the Loonie fell sharply in each year (6.6% in 2013, 8.6% in 2014 and 16% in 2015). Then again, the currency was coming off an extremely overvalued period following the financial crisis (remember par?).

 

There are some reasons behind the Canadian dollar’s sub-par (pardon the pun) performance this year that seem intuitive at first glance.  Let’s begin with oil and other commodity prices. Since June, the global price of crude has fallen more than 20% and, as of last week, a general measure of global commodity prices had declined 17% from the June highs. This factor, however, is more a short-term phenomenon and doesn’t explain what has happened to the currency since the start of the year. Even with this summer’s pullback in commodity prices, the TR/CC CRB index was still up close to 18% after it bottomed last week.

 

 

Another possible factor behind the Loonie’s fatigue might be the difference between interest rates and in the US. This differential is sometimes associated with the relative value of a currency. In other words, if we offer better rates on our bonds then international investors should be more attracted to our bonds (and currency) versus the US. This does hold some of the time, but definitely not this summer. Since the third week of May, when our 10yr government bond yield was equal to the US, our spread against the US 10yr rose and peaked at north of 0.3% at the start of July. During that period, the Loonie fell.

 

No, there has been a closer association between the value of the Canadian dollar and equity sentiment than our traditional drivers. If we look at correlations between the dollar and oil versus the S&P500, at least over the past 12 months, we see that the correlation with stocks is almost double that of crude oil. If we look back over a longer time horizon, the correlations are a lot closer. Not that commodities don’t matter anymore. If we had not have seen the rally in commodities this year, Canada would not be outperforming other major currencies against the greenback.

 

Larger waves in the currency world are swamping those factors that normally affect the direction of the Loonie. The US has been viewed as becoming the more aggressive major central bank in terms of tightening policy to battle inflation. That has drawn in flows from all of the weaker currencies I noted above. Again, this argument doesn’t apply to Canada since our central bank has already leap-frogged the Federal Reserve with last week’s mega hike. This week, we saw the European Central Bank (ECB) do something they haven’t in more than ten years – raise interest rates.

 

Considering that the ECB’s Deposit Facility rate has been negative since 2014, the fact that Thursday’s half-point increase took it back to zero was quasi-historic. Again, the head of the ECB commented that this move was a front-loaded move against inflation.

 

Sorry if I digress, but I am getting a little tired of central bank heads, including our own, saying that recent hefty rate hikes are “front loading”. I’m sorry, but front-loading would have been raising rates modestly last year when inflation pushed above target. True, no one really knew if the inflation surge was going to be very short-lived or longer; but policy is supposed to be pre-emptive and forward looking. Risk management if you will. Big rate hikes today are purely reactionary and a bow to the markets. Let’s go back to the analysis.

 

The ECB’s rate hike should have created a decent rebound in the euro, but that wasn’t the case either. There had been gains earlier in the week, but with Italy’s prime minister leaving and setting the stage for the country’s 68^th government since WWII. This political chasm sent a shock wave through the Italian debt market and the impact would have been worse had it not been for the news that Russia was going to resume natural gas shipments to Europe (albeit at 40% capacity).

 

 

Then there is the other major trading currency – Japan. The Yen has completely fallen out of bed versus the US dollar to the point that it is now trading at the worst levels since 1998 at north of Y137 to the greenback. The magnitude of this year’s sell-off has led to speculation that the Bank of Japan will have to intervene to protect the value of the yen. What the Bank is not doing is jumping on board the rate-hike bandwagon, leaving its key policy rate unchanged at minus 0.1%. Considering the global headwinds, maybe Japan has it right in creating a more competitive exchange rate environment for Japanese firms.

 

But let’s bring it back to Canada. Simply put, the direction of the Canadian dollar is going to be influenced more by global macroeconomic and policy factors than what is happening here, or what commodities are doing. If equity markets continue to improve, then the safe haven support for the US dollar should wane and this should leave the door open to a stronger Loonie. Of course, the opposite holds too. Where this gets a little complicated is if weakening global economic fundamentals (which would normally send currencies like the Loonie lower) cool inflation and hence rate expectations, thus supporting stocks.

 

As much as we are dealing with a July heatwave, winter temperatures are only four months away and that means snowbirds are starting to count down the days. Some will cover their US dollar requirements through US investments, like we do many of our clients. Still, some may be looking at stocking up on greenbacks and if this is the time to do it? My advice is to watch how the technical indicators unfold for the Loonie. Since March, each low in the Canadian dollar has been met with a lower low after a rebound. Last week’s closing low of 76.24 cents represents a new support and if any retracement takes to a new floor above that, then we can start talking constructively about the dollar into the autumn.

 

Playback details from this week's conference call:

Toll-free dial-in number (Canada/US): 1-800-408-3053

Local dial-in number: 905-694-9451

Passcode: 5147602#

 

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.