Market Watch: Canadian Dollar

As we speak, the Canadian dollar has hit a low (1.5590) against the euro not seen since May 2005. Although the Canadian economy hit a rough patch in the latter half of 2006, the economy has shown strong signs of recovery this year, with economic fundamentals reflecting a marked improvement thus far in 2007. In the most recent economic outlook report from the OECD for developed nations, Canada was the only economy of the leading nations that was seen to expand in the coming months, with a general slowdown being forecast for the wider group. Commodity prices, important to Canada’s corporate coffers, have rebounded in the past 2 months and Canada’s burgeoning trade surplus and massive energy reserves make it the envy of rest the world. Employment is flourishing and the Canadian construction sector has been booming, unlike in the US. So why is the country’s currency behaving like that of an emerging country, at the wilful mercy of currency speculators?There are a number of factors / reasons:

1) Trends. The Canadian dollar has been on a downward trend across the board since last summer, a decline that sharpened from October through to the end of the year. In the past year alone, the loonie has lost 14% of its value against the euro. That is a remarkable downward slide and the problem with long-run trends is that they are difficult to reverse, even when the fundamentals improve. Traders have gotten used to selling Canadian dollars and it will take quite a sizeable jolt in the other direction, before this selling mentality shifts.

2) Growth. The Canadian economy slowed considerably in the second half of 2006 and in fact it was the worst performing of all leading nations in quarter 4, recording an annual GDP rate of just 1.4%. Although growth has picked up significantly at the start of 2007, it is difficult to shift the negative market sentiment towards the currency, caused by the poor economic performance in the last two reported quarters.

3) Interest rates. Canadian interest rates have been on hold since last summer, at a time when interest rates have been on the increase in Europe and even in Japan. The Canadian dollar has become a less attractive currency to hold because of the widening in interest rate differentials between the loonie and other currencies like the euro and the pound.

4) Big brother / little brother pushover syndrome. Current concerns over a slowdown in the US economy are having a greater impact on the Canadian dollar than on the US dollar. If data is negative for the dollar, it is more negative for the loonie. Canada is one of the world’s most important providers of commodities, from oil to base metals and to precious metals. It is an export dependent nation. The Canadian economy is inextricably linked with that of the US - the US provides Canada with the bulk of its export market. If demand in the US falters, so do Canadian exports and consequently the Canadian economy. Traders have been finding it relatively easy to kick the Canadian dollar, when the US economy misbehaves.

5) Speculative positioning. There has been a very strong wave of short positioning against the Canadian dollar in recent months and even with a major revival in the economy’s fundamentals, traders have continued to stack short positions against the currency. The latest commitment of traders report from the Chicago Mercantile Exchange reveals that there are currently more short positions held against the Canadian Dollar than for any other of the major currencies. This is a startling statistic and given the shift in fundamentals of late, any one event could trigger a massive unwinding of these shorts which could see a very sharp appreciation in the Canadian dollar in the not too distant future. Despite several attempts in recent weeks by the loonie, its progress each time has been halted and reversed, not by a change in fundamentals, but by determined and successful efforts by unknown sources to keep the currency down.

6) Risk aversion. The Canadian dollar appears to have come off worse than nearly every other currency during the 2 financial market bubbles we have experienced in the past few weeks. First there was the unwinding carry trade, which saw the loonie lose over 2 cents to the US dollar in a few days. It is difficult to understand just why the loonie was targeted, given the fact that the volume of carry trades involving the loonie must have been small. Its interest rate – at 4.25%, is not amongst the most attractive on offer for carry traders and given the loonie has been on sharp downward trend since last summer, loonie longs must have been few and far between and all carry traders should have been long since sold out of the currency. This week’s scare about US sub-prime mortgages is more understandable in terms of its impact as it raises wider questions about the soundness of the US economy and by association the outlook for Canadian exports and the loonie. However, as to why the loonie should plunge more than the dollar is something of a mystery, but that is probably another example of the little brother pushover syndrome, which is shaping market sentiment right now.

Will the loonie ever come back with more than a whimper? Yes! Improving fundamentals demand a stronger currency and markets cannot ignore facts for too long. The timing of a real loonie revival may depend on US fundamentals as much as on Canadian ones. A stronger dollar would no doubt see an even stronger loonie, but given the current positioning against the Canadian currency, a single event could trigger a long overdue appreciation and genuine trend reversal. As to what that event may be, we just don’t know, but we sure don’t want to miss the bus.

Central Bank Watch

Both the ECB and Bank of England meet this Thursday and the outcome will have a major impact on the direction of each currency over the next month or so. The ECB will be raising rates to 3.75% but the key question is what will happen to rates thereafter. The market is expecting at least one more rate hike, probably in June, but in view of recent economic data and the uncertainty surrounding the prospects for the global economy going forward, a further rate hike is by no means assured. If the ECB President – Jean Claude Trichet, is perceived as being dovish in any way on Thursday, then the euro could face a backlash and we could see EUR/USD retreat to below 1.30 again. With euro zone inflation currently standing at a mere 1.8% combined with scares about the direction of the US economy and the euro economy itself showing signs of having peaked, Trichet may find himself unable to be as hawkish as he has done at recent meetings. While he is sure to refer to the upside risks to inflation of changes in energy costs, those seeking some concrete referral or coded signal, for a further impending rate hike, may well be disappointed. It will also be very interesting to see how Trichet responds to questions as to the ‘cause’ of the recent sharp reversal in global financial markets, a question he is sure to be asked.

The Bank of England has become something of an enigma in recent months and one never quite knows what to expect from them. Given their appetite for delivering the unexpected, a further surprise rate hike this week is not beyond the bounds of possibility. Production output, bank lending and house prices have been very robust in the past month and if February’s inflation data sees UK consumer prices on the rise again, then the Monetary Policy Committee may feel justified in acting now, rather than wait. Against that, UK retail consumption slumped in January and the country’s key services sector slowed in February. Fears over excessive inflationary earnings awards in the recent wage round have largely abated. Some Committee members are likely to opt for an increase this month, given that a minority two members voted for a rise at the last meeting. Unless consumer prices have risen unexpectedly again in February, it seems likely that the Committee will opt to keep rates on pat, allowing more time for recent rate increases to bed into the economy and to take a stranglehold on prices. The market certainly doesn’t expect a rate increase this week and if the Bank were to surprise yet again, then given the turmoil in financial markets over the past week, it may well prove to be this Committee’s least popular and boldest move to date. The Bank’s recent Inflation Report stated a requirement for a further rate increase in the second quarter, to bring inflation to within the target rate by the end of the year. We are not yet in the second quarter, but then again this is the Bank of England we are talking about.