In spite of a strong Canadian economy and rising domestic interest rates, the Canadian dollar has been trading at a discount relative to its fundamental value, largely due to trade risks, says a report by TD Economics.
“Our empirical work shows that over the last few years, non-fundamental or idiosyncratic factors are influencing the loonie to a greater degree. We estimate the downside impact of these factors, such as trade risks, to be on the order of about two to three per cent currently. That magnitude is down from five per cent in June,” said the report’s author, senior economist James Orlando.
He said that typical fundamental drivers of the Canadian dollar are also changing as energy prices are playing a decreased role, but yield differentials are increasing in importance.
“While 78 U.S. cents remains our year-end forecast, we would not be surprised to see the loonie temporarily rally towards (or even) above 80 U.S. cents in the near term if trade talks between Canada and the U.S. are successful,” said the report.
“The Canadian dollar has been stuck between two conflicting themes. On one side, the economy has been running ahead of expectations, unemployment is below its natural rate, and inflation has increased to the central bank’s target. With this backdrop, the Bank of Canada has kept up with the Fed in hiking its policy rate 100 bps in a year, providing support to the loonie’s nominal value. But, on the other side, Canada has a huge amount to lose when it comes to the U.S. administration’s trade policies.”
This trade-related uncertainty has been a dominant factor, leaving the currency at a significant discount relative to where it would be trading otherwise.
“Needless to say that there is much at stake at this week’s NAFTA talks, where a successful outcome could send the loonie back to its equilibrium value of around 80-82 U.S. cents, at least temporarily,” said TD Economics.
“When looking at trade, the risk to the Canadian economy is greater than that of most major global economies. The U.S. makes up 49.4 per cent of the trade-weighted Canadian dollar index. When Canada is facing a disproportionate economic threat from the U.S., the Canadian dollar adjusts accordingly.
“It just so happens that the other economies that have been in the tariff purview are also the next most important to Canada with respect to trade – China (13.1 per cent of total), Europe (11.1 per cent), and Mexico (8.5 per cent). Since March 2018, the trade-weighted Canadian dollar has appreciated around two per cent, but once you strip out the U.S. dollar from the index, the loonie has appreciated over six per cent. We believe that this rally, which attests to Canada’s recent economic strength relative to most major economies, has left the Canadian dollar at or above fair value versus the currencies of major trading partners, with the exception being the greenback.”
Mario Toneguzzi is a veteran Calgary-based journalist who worked for 35 years for the Calgary Herald, including 12 years as a senior business writer.