Canadian Dollar Goes Loonie, Reaching Parity with US Dollar

by Gary Dorsch, Global Money Trends. March 16, 2010

Having climbed so far, it’s almost a foregone conclusion the Canadian dollar would soon reach parity with the American dollar. The Loonie rose to 98.50-US-cents today, its highest level in 20-months, with only 1.5-US-cents separating it from the psychological US$1.00 target. The reasons used by the media to justify the Loonie’s strength are reminiscent of those heard back in November 2007 when the Canadian dollar rocketed to US$1.1040, its highest level since the late 1800’s.

“We have a strong economy, our federal finances are in very good order, almost every government in Canada is running a surplus,” Canadian Finance Minister Jim Flaherty said 29-months ago. “This is due to strength in our economy, and some of it of course, is being reflected in the currency,” he added. However, while Flaherty saw the cup as more than half full the Bank of Canada saw some very worrisome signals that were undermining the economy at the same time.

Canada’s trade surplus shrank -38% in Sept 2007, to C$2.65-billion from C$4.3-billion in the previous month, shriveling to its lowest level since December 1998 as exports in top sectors tumbled and the Canadian dollar soared to parity with the US-dollar. A few weeks later on Nov 20th, 2007, Bank of Canada (BoC) deputy Pierre Duguay warned “The sharp appreciation of the Canadian dollar warranted particular attention,” he said. Paul Jenkins, senior deputy at the BoC, warned currency traders that the “Loonie's rise was “outside normal bounds.”

Crude oil was approaching the psychological $100/barrel for the first time ever, buoying the Canadian petro-dollar, and the BoC was at the top of its tightening campaign, pegging its overnight loan rate at 4.50-percent. Fearing that a global “Oil Shock” and the US-sub-prime debt crisis could suppress US-demand for Canadian exports of manufactured goods, the Bank of Canada took prompt action to undercut the strength of the Loonie by cutting its overnight interest rate a quarter-point to 4.25% in what would be the first step on a long journey of slashing rates to a historic low of 0.25-percent. Thanks to the BoC’s “jawboning” and rate cut, the central bank engineered an 11% decline in the Canadian dollar from a historic high of $1.1040 to around 98-US-cents, much closer to the BoC’s comfort level.

Fast forwarding to today, the Loonie is once again threatening to reach parity with the US$, but this time in a radical twist of circumstances, the Bank of Canada doesn’t have any room to cut interest rates to weaken the Loonie. The Canadian economy grew at a sizzling rate of +5% in the fourth quarter, outpacing the BoC’s prediction of 3.3% growth. Inflation has also picked up, accelerating at close to the central bank’s 2% target amid a boom in global commodity prices.

Yields on overnight index swaps, which trade based on expectations for the BoC’s key interest rate, edged higher to 72-basis-points this week, indicating that traders expect the BoC to hike its rates by a half-percent in the second half of the year. Meanwhile, the radical inflationists at the Federal Reserve are telegraphing their intention to keep the US fed funds rate locked at zero-percent for an indefinite period of time, which in turn could lead to higher prices for Canadian commodities.

The Loonie has rebounded from a crash bottom low of around 78-US-cents at this time a year ago to 98.50-US-cents today, climbing higher on the back of soaring crude oil and copper markets, the kingpins of the commodity complex. With commodities accounting for 35% of Canada’s exports, the Loonie is reaping the rewards of a virtuous cycle. Canada is the world’s second largest holder of oil reserves, the ninth largest copper miner, with annual output of 600-million tons, and the eighth largest gold miner, with 3.6-million ounces of annual sales.

Although crude oil prices are moving above OPEC’s perceived target zone of $70-to-$80/barrel, to just below $82/today, the oil ministers of Saudi Arabia, Qatar, and the UAE met in Vienna on March 16th and ruled out a boost in output anytime soon, declining to rein-in speculative “hot-money” inflows into the oil market. “I think that the only way at this time is to go with a rollover,” said Qatar's Abdullah al-Attiyah.

Crude oil prices are on an upward trajectory even though most members of the OPEC cartel are cheating on their self-imposed quotas to the tune of 2-million barrels per day. Compliance with output curbs has steadily fallen over the past eleven-months to just 53% in February, down from 81% in April 2009. Meanwhile, the demand for copper is supported by Beijing’s $585-billion stimulus package. The rapid build-up of copper supply is deceiving since banks and other speculators are engaging in “contango financing” - buying cash metals cheaply and simultaneously selling forward at higher prices, earning the difference.

Fears of additional moves by the People’s Bank of China to tighten its money supply, after two increases in bank reserve requirements to 16.50%, are beginning to subside in the psyche of global commodity markets. Beijing hasn’t shown the political will to hike interest rates on bank deposits which are about a half-percent less than China’s official inflation rate. Negative interest rates in China are fueling speculative interest in gold, the world’s biggest retail buyer of the yellow metal, and indirectly buoying the value of Toronto listed gold miners.

While the Loonie is reaching for parity with the US-dollar it’s also bumping against 90-yen, where it's encountered stiff resistance against the Japanese currency on four previous tries over the past 12-months. Last August, Canadian MoF chief Flaherty threatened outright intervention in the currency markets to halt the Loonie’s rise, but this week he seemed unperturbed by the uptrend.

“There’s some upward pressure on the Canadian dollar, but it’s a market currency, and we believe in markets, and when you believe in markets, you have to let your currency float. To some extent Canada’s relatively strong fiscal position is assisting the rise in the Canadian dollar. So far, we haven’t seen extraordinary volatility,” Flaherty said, giving speculators the green light to bid-up the Loonie.

Canada is running a budget deficit of about C$53-billion this year, after a decade of surpluses, but its debt-to-GDP ratio of 29% remains the lowest in the Group of Seven major industrialized economies. According to the IMF, Canada’s budget deficit will be 4% of economic output this year before tapering to 2% in 2011. Not so in Japan, where overall debt levels are predicted to reach 220% of GDP by March 2011.

Yet yields on Canada’s 10-year government bond are 2.10% higher than those in Japan, making Canada’s bonds a better bet for longer-term safety. In fact, foreigners bought an unprecedented C$82.5-billion of Canadian bonds last year, up from C$15.2-billion in 2008. For Japanese investors, buying the Canadian dollar could look like a smart move if the Bank of Japan succumbs to massive pressure from Tokyo to inflate the supply of yen further, to fight the myth of deflation.

On March 12th, the Nikkei newspaper said the Bank of Japan would double the funds it injected into local banks at the emergency meeting in December to 20-trillion yen ($221-billion), flooding the global money markets with yen. If correct, that could be the catalyst for the Loonie to penetrate stiff resistance at 90-yen. An easier BoJ money policy could also boost gold and commodity prices worldwide, - yet another favorable sequence of events that could increase speculative flows to Toronto.

Gary Dorsch

© 2010 Gary Dorsch

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