- Weakness in the Canadian Economy driving its currency lower
- Inverse relationship between commodity prices and USDCAD exchange rate
- Why there could be a reversal in trend
How did the Canadian currency reach a twelve year low?
The US Dollar reached a recent high against CAD at 1.41081 on January 6th a level not seen since August 2003. The general bull trend the green back has been in picked up momentum since talk begun by the Fed of a return to higher interest rates.
A weaker economy will cause a currency to devaluate compared to the currency of a country with an expanding economy. It will also be enough for an economy expanding faster to see its currency appreciate against the currency of an economy that is expanding but at a slower pace.
The chart below shows annual GDP Growth for Canada and the US on a quarterly basis. It’s clearly visible how the US economy has been outperforming the Canadian economy. The US economy since 2014 has seen a GDP Growth rate above 2% while the Canadian GDP Growth rate has faltered to 1.2%
Another Macroeconomic factor that will drive FX rates is unemployment, again as it is considered a gauge for economic health. Unemployment in Canada is currently at 7.10% and is on the rise coming from 6.6% in January 2015. The unemployment rate in the US is currently at 5% and looks like it is on the way down coming from 5.7% in January 2015.
Inflation also has an effect on exchange rates as a currency that experiences high levels of inflation will see its FX rate depreciate against currencies with lower inflation. Canadian inflation [10] is currently at 1.4% compared to inflation in the US at 0.50%. Add to this general macroeconomic narrative an increase in interest rates in the US and the Loonie [10] had nowhere to go but down.
Commodity price and the Canadian Dollar
The Canadian Dollar is considered to be The commodity currency for its high correlation to commodity prices. This is due to the large percentage of exports that commodities like crude oil and other energy products account for.
Canada is a major exporter of various commodities, Crude Oil and other energy products being its main export. Crude Oil exported 2.6 million barrels per day in 2013, even at today prices that’s around $91 billion worth of exports. Gold [11] is also an important export for Canada; in 2014 the country exported a total of $20.3 billion [12] in precious metals and gems.
Canada on a global level ranks only 6th as a producer, but it is the world’s second largest [13] exporter of wheat. The country exports $7.2 billion of this commodity per year, second only to the US.
The USDCAD exchange rate can add pressure to the price of these commodities and vice versa, as all of these commodities are quoted in US Dollars. If a commodity falls in price by 10% but the exchange rate increases by 10% then a Canadian producer will see his revenues unchanged. The decrease in commodity price is offset by the increase in USDCAD. Basically as the exchange rate rises a Canadian producer will receive more Canadian Dollars when they sell the US Dollars they cashed in from the sale of the commodity.
It’s hard to determine which moves which, or to establish which is the driver of the other. But there is a clear correlation between the two prices. The chart below shows the price movement of a basket of commodities versus the USDCAD exchange rate from September 2012.
Why is a reversal likely?
The USD has had an amazing bull run over the past 2 years with increases against all major currencies. It is currently at a 30 year overbought level [14] according to some technical indicators. This alone could see a correction in the bull trend. But when comparing the Loonie to other major currencies we also see that it’s the currency that has lost the most.
In 2015 alone the Canadian Dollar lost 17.35% compared to 9% decline for the Euro. Over the past 2 years the Loonie has depreciated by 33%, while the next biggest loss was for the Euro which has dropped 20% over the same period. Other currencies like the Pound Sterling and the Japanese Yen have lost 10.50% and 11.75% respectively over the last 2 years.
There may also be a rebound in commodity prices over the next year. This will put downward pressure on the USDCAD exchange rate as we saw earlier. Crude Oil may see a spike due to geopolitical events in the Middle East. Gold may see its price increase if there is a sharp correction in the broad stock market, something which is beginning to seem more likely recently. Other commodities may see an increase due to inflationary pressure. Many commodities, or their derivatives, are constituents of inflation baskets. When considering Wheat by looking at the ETF WEAT:Arca [14] we see price has fallen by 65% since it reached a high in August 2012. There certainly seems to be a lot oversold pressure on most commodities.
The fundamentals of these currencies have not changed, so the medium term trend is most likely to remain intact. But high overbought levels of the US Dollar and a rebound in commodity prices could see a major correction in the USDCAD exchange rate.
