"The potential for Canadian dollar buying is just tremendous." Unnamed "senior currency strategist" at "Big Bank", Dec. 22, 2005.
We see at least seven reasons why the Canadian dollar's rise against the US dollar may finally come to a close. Yes, we recognize that it's always tough to call currency moves, but the run-up in the dollar has all the classic hallmarks of an unsustainable - we would even say, maniacal - top. Above all, expectations are as skewed as ever. One of the most compelling trades we can see for Canada-domiciled investors right now is to partially swap cash balances into US dollars. In this post-Bretton Woods II, environment, where simple interest-rate arbitrage can drive currency movements almost single-handedly (completely delinked from quality considerations and classical currency theory) the fact that the dollar has recently soared with such relatively low interest rates, (compared to the US) is a remarkable triumph of "bullish sentiment."
Mea Culpas
We wrote an article almost a year ago on the Canadian dollar, in which we dubbed it "The Most Respectable, Speculative Currency in the World." In retrospect, our perspectives were correct - indeed the Canadian dollar is both respectable and speculative - except in one critical respect: the canuck buck is 3% higher than it was a year ago. While the dollar did fall some 7% from its top in late 2004, here a year later, it is near 13-year highs. What we didn't anticipate - and should have known, of course - was a post-Katrina environment where the Canadian dollar would come to be traded as a "petrodollar."
There is no question that the Canuck buck continues to be one of the world's favorites at this time, having now risen as much as 40.1% against the USD from its early 2002 all-time lows. In fact, there is almost universal bullishness at present (a cautionary factor to consider right now ... at least over the short-term!). What goes up fast can also come down just as quickly ... especially so in the case of the Canadian dollar. Through no fault of its own, Canada's currency will remain highly reactive for structural reasons.
Could the Canadian dollar really be a speculative currency as we surmise? After all, Canada is a secure country with a sound balance sheet - i.e. no problems with runaway budget deficits or exploding external deficits. In fact, quite the opposite is true. But, its currency also has a higher daily volatility than the Mexican peso (by at least 25%) and can experience enormous, dislocating swings. In Canada's case, the high volatility of its currency is the curse of being a respectable but small currency in the world, one that doesn't have very much monetary independence. The Central Bank of Canada, constitutionally at least, does have clear independence. But, in the Age of Global Capital (one with totally free cross-border capital movements) monetary sovereignty for a small economy like Canada hardly exists.
In our view, the arguments identifying a "high-risk" top in the Canadian dollar are more compelling than ever.
7 Reasons Forewarning of a Top
1. Unprecedented Adjustments to Date. For a start, let's establish some perspective on the rise of the Canadian dollar to date. From the US dollar's high of 1.6128 CAD on January 18, 2002, the run-up of the Canadian dollar has been unprecedented in degree and rapidity. Compared with a previous period of appreciation between February 1986 to August 1990 (see Figure #1 on the front page) the recent run-up of the Canadian dollar has been a third larger (40.1% vs. 27.1% earlier) and over a shorter period of time (47 months versus 54 months). That's incredible enough in its own right. But consider this: The trade intensity of the Canadian economy today is nearly double what it was in 1985. That makes the Canadian dollar move to date an even more brutal one for Canada's trade sectors. (We elaborate on this point further in Reasons #2 and #3.)
Given the extent of the currency adjustment experienced by Canada to date, one may sense how comical are some of the forecasts still being proffered lately. Some analysts are confidently forecasting that the Canadian dollar will continue rising against the US dollar, possibly reaching parity with the USD (amounting to a cumulative gain of 60%!). Of course, these predictions are all safely within the popular view. But they border on the ridiculous, especially when also considered on the basis of the next two points.
2. High Trade Intensity. Canada's currency movements cut deeply. As a country, it has one of the highest dependencies upon trade of goods and services of any major, high-income nation. Figure #2 provides a relative perspective upon this high trade intensity. Canada's imports plus exports (taken as a ratio of domestic gross product) is multiples larger than, for example, Japan, a country widely perceived to be a mercantilist, trade-sensitive economy. Japan heavily intervenes in the currency markets in order to ensure that the yen does appreciate "unmanageably." Its politicians and industrialists whine loudly when the yen becomes overvalued. However, even though Canada is hugely more trade intensive than Japan, financial market participants seem to think that a 40% appreciation in the Canadian dollar shouldn't have any similar consequences. Strangely, even Canadian politicians don't sound the alarm very much. Why?
3. Extreme Currency Sensitivity. While Figure #2 shows that the countries of Ireland and Malaysia are even more trade intensive than Canada, there is a big difference. Both of these economies are not nearly as "currency sensitive." Ireland transacts much of its trade inside the pound sterling bloc. And Malaysia? It's one of those nations that that won't allow its export economy to be taken hostage by either currency speculators or the IMF. It has pegged the Thai baht against the US dollar since 1998.
Consider that the Canada-US trade relationship is one of the largest in the world, accounting for a total flow of goods in excess of $450 billion. That means that Canada is a nation with the greatest part of its economy dependent upon the most amount of intra-country trade with any one other nation (almost 30% of Canada's GDP). Next, remember that that "one other" country - the US - has a different currency. Other bilateral relationships that rival Canada/US trade in relative size are conducted in the same money. The euro-zone countries of Europe provide cozy examples. The point we make is that given the enormity of Canada's trade relationship with the US, huge currency swings of the kind witnessed to date are suicidal. While a stock price might jump 40% easily enough, a currency movement of this magnitude is a monumental dislocation, effecting large reallocations of a nation's capital and resources.
4. A Thin Trader. Clearly, Canada's economy is one of the most - if not the most - currency sensitive in the world. What's more, the Canuck dollar is also one of the thinner traders in global exchange markets, a counterpart to only a little more than 4% of all exchange trading by volume. No wonder it can be volatile. Though Canada may now have the world's 5th largest stock market, its currency is still a small fry. It therefore requires relatively little capital from the rest of the world to move it either up or down. That's a key point to keep in mind. When the Canadian dollar finally turns, the trend can snowball ... especially so if starting from a speculative, over-owned top.
5. Vulnerable Overvaluation Zone. Our proprietary currency valuation measure (see Figure #3 below) indicates that the Canadian dollar is now in a "high risk" valuation zone against the US dollar. This measure is based upon classical currency theory and has proven to be a trusty guide in the past. When in "high risk" overvaluation zones, the probability of a currency downturn is significant enough to mandate protective hedging of foreign assets held in investment portfolios. This would be true from the perspective of portfolios based in USD. On the other hand, for Canadian investors, our valuations barometer is signaling an ideal season to diversify into international assets. As mentioned, short-term currency predictions are highly unreliable. However, identifying a high risk zone for various currencies has worked well in the past, allowing us to lower portfolio risk while at the same time boosting relative returns.
6. Negative Interest Rate Spreads. Currently, Canadian interest rates - both short and longterm - are below US rate levels. (See Figure #4) Yet, the Canadian dollar remains strong. As already pointed out, lately the dollar has even been flouting the new "post Bretton-Woods II" currency regime of high yields leading to strong currency performance.
Once upon a time, trade flows may have determined short- and long-term currency trends, but not reliably so any longer. At last count (April 2004) the Bank of International Settlements (BIS) reported that daily exchange turnover amounted to $1.9 trillion. At that pace, it takes only 5 days to surpass the total of one year's worth of world trade in goods and services. Today, we see a system that considers currencies primarily as speculative investment vehicle, not as a means to regulate sound money between countries. Higher interest rates are considered virtuous and not as maladies - symptoms of countries sick with inflation or any other imbalance. The hot money rushes in, chasing higher yields, thereby pushing the currency upwards.
Then what is driving up the Canadian dollar if yield spreads are no longer supportive? If not "hot money" (likely pulled in initially by higher short- and long-term interest rates in Canada than were on offer in the US) we conclude that it must now be "mania money."
7. Economists and Contrarian Psychology. One of our last comments is reserved for economists. Nary a word is heard from any of them about the Canadian dollar being vulnerable - not even from Canada's economists. Virtually to a person, they remain "bullish" ... surely a contradiction in terms spoken from forecasters north of the 49th parallel. A higher Canadian dollar is hardly a "bullish" event for Canada. For now, it's important to note that speculative fever with respect to the dollar is already high. According to the Commitment of Traders Report on the Canadian dollar futures contract traded on the Chicago Mercantile Exchange (thanks to Henry K. To of Markethoughts.com for the heads up" on this statistic), the positions of small and institutional traders are now at an unprecedented high. This condition very likely may herald an upcoming turning point for the buck.
We see more than just anecdotal information that Canadian fund managers might be whipsawed, as well. After three years of having international assets returns pummeled by exchange translation losses, some prominent mutual funds have thrown in the towel. They are switching to a fully-hedged status (after the horse is already out of the gate and has a 40% head start!). Also, earlier in December, Barclays i-Shares converted two of its Toronto-listed foreign-content ETFs to a fully-hedged status. The timing of all these moves may not be auspicious. All the same, professionals remain bullish on the Canadian dollar ... in droves, no less. According to a recent Russell Canada survey, only 7% of fund managers are bearish on the Canadian dollar. Who's left to put in the last marginal trade for a dollar top?
Given the above points, if the Canadian dollar is going to rise any higher, it'll have to be carried by imaginative storytelling, not the weight of rational money. Admittedly, the stories are very catchy. China and the other fast-growing newly industrializing countries (NICS) in Asia and elsewhere are starved of commodities. They need them; Canada's got them. Therefore, the dollar will continue to soar. Or, how about the fact that Canada is now a world oil power? Ever since one of the global oil surveys decided that Canada's high-price oil sands should be counted as probable reserves, Canada has shot up to the #2 position in the oil-rich league (right between the House of Saud and Russia). Last year, Canada even graduated to becoming the largest exporter of oil to the US.
Indeed, Canada is richly blessed with natural resources as well as a large stock market exposure to this sector. However, it is one thing to argue that resource stocks should rise in price, but it doesn't follow that this should drive up the Canadian dollar to hugely overvalued levels ... definitely not in a world where most commodities are priced in US dollars. While commodities may indeed stay on the strong side for a decade or more, they nonetheless will remain cyclical. Corrections most certainly must be expected. If so, the new Canadian "Petrocurrency" will not be immune.
But really, is it logical that the Canadian dollar should soar higher because of booming commodity prices? It's actually counterproductive.
The International Division of Commodities and Gains
The "commodity stories" miss a key point. A rising Canadian dollar acts to denude Canada of rising commodity prices. While the price of copper and oil may have soared in US dollar terms, that's not necessarily so in Canadian currency. Ramping up the Canadian dollar in effect depreciates the commodities gold rush to Canadians and undermines domestic earnings of it commodity producers. As it is, Canada's pulp and paper producers are already on the ropes.
Take a look at Figure #5 showing the price of gold in Canadian dollars. The world may have enjoyed a soaring bullion price, but Canada - one of the world's major producers of gold - has been mysteriously stuck in a narrow price range for many years. Does that make sense? Is there a conspiracy at work, or are global investors exhibiting signs of a dollar mania?
Fact and reality is that there is absolutely no correlation between national prosperity and a resource legacy. Think of the industrial dynamos of the world - Japan, the Netherlands, Taiwan ...etc. They were (and remain) resource-poor. What about South Africa or Argentina? Why aren't these resource-rich nations amongst the world's highincome countries? Some scholars even conclude that there may be a reverse relationship.
A soaring Canadian dollar is doing no favors for Canada. For one, it acts to hollow out its own industrial sectors, forcing it to focus upon resources industries. Secondly, it diminishes the potential earnings of its resource companies as commodities tend to be priced in US dollar terms.
Also significant is that a rising home currency causes investors to stop diversifying portfolios internationally. That is proving to be the case as global equity and bond returns look disastrous when translated into Canadian dollar terms. (See Figure #6). While USbased investors have been enjoying excellent returns on international assets in recent years, (up over 50% on EAFE equities since Dec. 31, 2001) Canadians have given back some 40 percentage points in potential return because of a rising dollar. The same phenomenon occurred as in the late 1990s when the S&P 500 was the world's favorite investment. Who needs diversification when a single bet keeps winning, or so many investors may believe?
Final Conclusions: Speculative Top?
Canada has become a favorite destination for investment capital that fits the times - rising commodity prices, booming energy, and soaring resource and oil stocks. In the process, the Canadian dollar has embarked upon loonie lunacy. A telling flipside is that Canada has become an unpopular tourist destination - in the past, usually a result of an overvalued currency. Visits to Canada in October of 2005 were the second lowest in 12 years (August 2005 was the lowest). A similar phenomenon occurred in the late 1980s. People only let their money take a vacation to Canada, eventually getting their pockets pinched.
In our analysis, the Canadian dollar is vulnerable. All aspects considered, currency swings of the scale experienced over the past few years must be considered far outside the norm. Even as Canada's economy has continued to integrate with that of the US (over 40% of all trade is now intra-company) its currency has experienced ever greater swings not to mention short-term volatility. It is surprising there hasn't been greater public concern, especially given the current federal election campaign.
Repeating our opinion of almost one year ago, the Canadian dollar (if ever it finds its norm, given its frothy existence) would be well valued at the 72 cent level ... perhaps even as high as 76 cents. We don't know when that will happen. However, we think the probabilities are asymmetrically in favor of 72-76 cents rather than par against the US dollar.
Canada is one of the most currency-sensitive economies in the world. And, to boot, it has one of the most volatile, skittish exchange rates. What makes that a cautionary comment, is that the Canadian dollar is now as overvalued as it has been at any other time over the past 25 years and virtually everybody is bullish.
And, all this at a time when it is relatively inexpensive to short the Canadian dollar.
A decline in the Canadian dollar will be good news for Canadian investors. At long last, that will boost returns for internationally diversified portfolios ... perhaps for several years. The opposite will prove true for foreign investors in Canada.
At the very least, it makes sense to move partial cash positions out of the Canadian dollar and into US deposits.
