The Loonie’s Wild Ride

For traders active in the forex markets, 2007 has been a fascinating year and 2008 promises to be just as exciting. Everyone has been caught up in the record retreat of the U.S. dollar against the major currencies, but it may be the Canadian dollar that has had the most interesting story lately.

The Canadian dollar has always been secondary to the mighty U.S. dollar and this is reflected in nick names like the “little buck” or “junior dollar”, but these names may not be appropriate given recent events. Therefore, we’ll stick to another standard moniker – the “loonie” – so-named because of the loon (a commonly-seen waterfowl) on the back of the Canadian dollar coin.

In late October 2007, the loonie reached parity with the U.S. dollar for the first time in over 40 years. While this fact is newsworthy on its own, it is the way that parity was reached that makes this a truly “wild ride” for investors. This was no slow ascent that took years to play out – instead, in less than a year, the loonie went from .85 USD on January 1, 2007 to a high of just over 1.10 USD by mid-November. ^[1]

Two events are responsible for this reversal. Firstly, the U.S. dollar has retreated against most of the world’s major currencies as the subprime problems continue to haunt the U.S. economy, and secondly, the price of oil continues to climb on the world markets.

Canada has the second highest level of oil reserves on the planet, with a good percentage of that oil in the “tar sands” in the province of Alberta.^[2] A costly extraction process is necessary to recover this oil but with world prices pushing new records, the tar sands have become more feasible and output has increased dramatically.

While oil prices closing in on $100 a barrel makes for heady times in the oil-producing regions of Western Canada, the traditional manufacturing centers in Ontario and Quebec are facing an uncertain future. For several decades, Canadian exports enjoyed the advantage of the relatively week Canadian dollar making Canadian exports especially attractive to global buyers. As the loonie gained in value however, the cost of exported goods increased and sales outside the country have suffered. Job losses in the manufacturing sector alone have topped 300,000 as of the end of October 2007. ^[3]

In response, provincial governments in Ontario and Quebec have called for a reduction in interest rates to make the loonie less attractive to investors in a bid to weaken the dollar on the forex markets.

At the same time, the Bank of Canada has been keeping a close watch for signs of inflation. Despite the booming economy in the west, overall Canadian numbers for October 2007 show inflation at 2.4 percent, down from 2.5 percent the month before but still within the Bank of Canada’s target range. Also, the Core Consumer Price Index for August was two percent lower than the September Core-CPI. ^[4]

Given these results, investors are lining up to predict what action the Bank of Canada will take at the next interest rate announcement scheduled for December 4. Recent comments from Governor David Dodge on November 20 suggest that an interest rate cut is under consideration when he noted, “It’s quite clear the downside risks to world growth have increased since policy makers from the Group of Seven nations met in Washington a month ago”. ^[5]

While this does not mean that a rate cut is a sure thing, based on the tone of Dodge’s comments, some market watchers certainly seem to think a rate reduction is coming. Meanwhile, the loonie has lost ground to the U.S. dollar, opening on November 2 at just over $1.01652.^[6] With the next interest rate announcement still more than two weeks away, the street seems to be leaning towards a rate reduction despite the eight cent drop from the previous high earlier this month.

As the loonie appears set to pull back to parity with the greenback, the question is what will happen with interest rates at the next Bank of Canada meeting? More importantly perhaps, what is in store for the U.S. dollar? Based on the recent warnings from the Federal Reserve, we may have yet to see the worst of the subprime fiasco so this slight rebound of the U.S. dollar may be short-lived. If this is the case, the loonie may regain some lost territory, but look for investors to increasingly turn to the euro for protection from a further devaluation of the U.S. dollar.

You might also want to fasten your seatbelt – this ride is sure to continue for a while yet.

Updated – December 5, 2007

At 9:30 AM on Tuesday, December 4, 2007, the Bank of Canada announced that it was reducing its overnight target rate by 25 basis points to 4.25 percent. Speculation was pretty-well split evenly leading up to the announcement date but with the recent pull-back of the dollar to just below parity with the U.S. dollar, many speculators felt that the Bank would hold off on a rate cut until the next announcement date on January 22, 2008.

In his address to the media, Governor Dodge noted that the recent drop in the loonie did reduce some of the pressures felt by Canadian exporters for the past few months. However, the Bank of Canada highlighted the October core inflation rate of 1.8 percent as a concern that the Canadian economy was slowing down – the Bank also cited continuing effects from the subprime credit crunch as still being a factor. Clearly, the Bank feels that spending has slowed in Canada and to ensure that this trend does not continue, the Bank decided to provide a boost by cutting interest rates.

In summarizing the interest rate cut, Governor Dodge noted, “All these factors considered, the bank judges that there has been a shift to the downside in the balance of risks around its October projection for inflation through 2009”.^[7]

The rate announcement had an immediate effect on the dollar and those that shorted the loonie stood to make sizable profits. The loonie lost three quarters of a cent in trading by the end of the day in New York and continued to fall overnight.

Related Links

Bank of Canada

References

1. ↑ Source – OANDA FXHistory
2. ↑ Energy Information Administration website
3. ↑ Toronto Star – November 21, 2007
4. ↑ Toronto Star – November 21, 2007
5. ↑ Bloomberg News – November 21, 2007
6. ↑ Source – OANDA FXConverter
7. ↑ Chronicle Herald Business – December 4, 2007