Currency Correlations, Part II: Canadian Dollar Begins its Decline

In April, I wrote a post entitled, “Economic Theory Implies Canadian Dollar will Fall,” in which I argued that the currency’s impressive rise was belied by fundamentals. It seems the gods of forex read that post; since then, the Loonie has fallen 3% against the US dollar alone. Based on my reading of the tea leaves, the loonie will fall further over the coming months, and finish the year below parity.

My contention is basically that investors are falsely treating the Loonie is a high-yield growth currency, and hence, bidding up its value. There are a few reasons why I believe this viewpoint is completely erroneous. First of all, Canada’s economy is both plain and mature. While it is indeed rich in natural resources would seem to make it stand-out, commodities exports account for only a small portion of GDP. Given that the US absorbs 75% of its exports, it’s no accident that Canada’s economic fortunes are tied closely to the US. Finally, Canadian interest rates are pretty mediocre, which means there is neither a strong monetary nor an economic impetus for buying the Loonie against the dollar.

While Canadian GDP and inflation have exceeded analysts’ predictions, the consensus expectation is still for the Bank of Canada to hold off on tightening until September or so. Even the most bullish forecasts show a benchmark interest rate of only 1.75% by the end of 2011 and perhaps 3% at the end of 2012. In other words, it will be a long time before the Loonie becomes a viable target currency for the carry trade.
According to OECD models, the Canadian dollar is overvalued by 17% against the Dollar on a purchasing power parity (ppp). While it is generally dubious to apply this concept to currency markets, I think it’s reasonable to invoke it when analyzing the USD/CAD. The two economies share more than just a border. As I said, their economies are closely intertwined, and goods, services (and people!) move freely between the two. Thus, you would expect that large discrepancies in prices should disappear over the medium-term. In fact, the Canadian trade balance recently slipped into deficit for the first time in 40 years (corresponding with the Loonie’s record high level), which shows just how quickly consumers can shift their attention south of the border. That means that either Canadian prices have to decline (something which retailers are always reluctant to effect) or the Loonie must drop further against the Dollar.

Of course, there is a mitigating factor: the US dollar may fall even faster than the loonie. While it would seem impossible to tease apart the loonie’s rise from the dollar’s fall (since a rise in CADUSD inherently reflects both), we can still make an educated guess. For example, consider that the Canadian dollar is strongly correlated (i.e. greater than 80 or less than -80 in the chart above) with almost every other major currency, relative to the US dollar. If the correlation was low, than it would imply that the Canadian dollar is fluctuating (in this case falling) for endemic reasons. In this case, however, the almost perfect correlation with the majors shows that it is almost definitely a US dollar spike rather than a Canadian dollar correction.
Whether this trend continues then, depends more on the health of the US dollar and less on what investors think about the loonie.