The disparity between USDCAD spot and PPP-implied exchange rates has narrowed from the extremes but remains significant at over 1800 pips. Since 2002, the Canadian dollar has experienced a dramatic reversal of fortune against its US counterpart. This paper examines the factors that contributed to the rise in the Canadian dollar in 2003. Economic theory and empirical evidence have identified a number of factors known to affect movements in exchange rates. In general, the value of the Canadian dollar relative to the US dollar is influenced by two distinct categories of catalyst. Perhaps the most significant domestic influence on the Canadian dollar is the relative health of the Canadian economy. The difference between interest rates in Canada and the United States is also a major determinant of the exchange rate between the two currencies. Differences in inflation rates between Canada and the United States also affect currency movements in the long term.
The current account measures the flow of goods, services and investment income between Canada and the rest of the world. A current account surplus means that since Canada is selling more than it is buying, there is a net flow of money into Canada.
Because Canada is a large producer and net exporter of resource-based goods, the Canadian dollar is often referred to as a commodity-based currency.
That the rise in the Canadian dollar is in large part a US-based phenomenon is evident in the fact that the Canadian dollar is not the only currency to have appreciated against the US dollar since 2002. The significant difference between the performance of these (and other) currencies and that of the Canadian dollar is the period in which the bulk of the currency appreciation took place.
Energy prices have been considerably more volatile than non-energy commodity prices, but they too are having an impact on the Canadian dollar. Moreover, some believe that the influence of energy prices on the Canadian dollar is increasing as Canada continues to grow as a producer and exporter of energy. As a member of the International Monetary Fund (IMF), Canada was committed to the Bretton Woods system of fixed exchange rates. In this report, the exchange rate refers to the cost, in Canadian dollars, of buying a unit of foreign currency.
The Canadian dollar would, in all likelihood, rise against the currencies of other slower growing economies. As stated earlier, however, economic growth differentials between Canada and the United States also affect the value of the Canadian dollar. Currently modest rate expectations for both the Bank of Canada and US Federal Reserve suggest it will take a noteworthy shift in rhetoric to move the USDCAD through the foreseeable future. USDCAD drifted further into undervalued territory in January, with prices now 17.6 percent removed from their PPP-implied fair exchange rate.
Markets expect the Bank of Canada to be the most aggressive in 2011, as they price in 82 bps in tightening compared with the next closest at 55 bps. The disparity between USDCAD and its PPP-implied exchange rate widened in December, Canadian Dollar now 16.9 percent overvalued relative to its US counterpart. The Canadian Dollar has proven far more sensitive to shifts in the Dow Jones Industrial Average and global commodity prices.
Thus USDCAD traders would likely do better in tracking crude oil and broader commodity markets as they trade the Canadian currency.
While a steadily improving US economy will eventually give the Canadian Dollar an edge over the currencies of other commodity-producing countries where demand is tied to China and Europe, both of which are expected to decelerate through 2013, BOC rate hike expectations have yet to start reflecting that trend. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. That decision was made in response to growing concerns about inflationary pressures in Canada and a rising level of foreign indebtedness.
Indeed, economic indicators had pointed toward a higher Canadian dollar for a number of years before its eventual rise.
And though the Canadian Dollar’s correlation to benchmark oil prices has weakened as of late, we would expect the USDCAD to remain under pressure on continued rallies in energy commodities.
With US economic data looking increasingly encouraging and the inflation rate nudging closer to the upper edge of the target band at 3 percent, a further widening of the value disparity seems likely as rate hike expectations mount.
Indeed, current consensus forecasts suggest that the gap in benchmark interest rates is will shift by a further 75 basis points in the Canadian Dollar’s advance over the course of 2011, with only the New Zealand Dollar being promised an equally robust monetary policy landscape. However, policymakers have loudly bemoaned the pain inflicted by the stronger currency, hinting that the Bank of Canada will hold out as long as possible before making a move toward tightening.
We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.
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