Tuesday, December 04, 2007

The Rise And Fall of the Canadian Dollar

Bank of Canada, which controls the monetary policy of the world's sixth largest currency zone (After the U.S., the Euro area, Japan, China and Britain) cut interest rates by a quarter per cent today. The stated motive was "global financial difficulties" related to the U.S. subprime mortgage crisis as well as lower than forecasted inflation.

However, the reason for the downturn in inflation was the dramatic appreciation of the Canadian dollar against the U.S. dollar until just recently. That not only made energy prices rise a lot less than in the U.S., but also put strong pressure on Canadian retailers to lower prices as customers threaten to shop south of the border or at least expressed anger over the failure to cut prices. As a result, consumer price inflation have risen a lot less than in the U.S. and so-called core inflation actually fell in October.

However, these gains are now threatened by the fact that much of the Canadian dollar's gains have been reversed. While the euro, the yuan and the yen is near their 2007 highs versus the U.S. dollar, the Canadian dollar have lost 10% against the U.S. dollar in the latest 4 weeks (including today's decline). This threatens to again push up inflation nearer the U.S. levels. As this decline is partly related to today's cut (The oil price correction is another key factor behind the decline in the Canadian dollar), this ironically means that the Bank of Canada by pursuing this cut at the same time swept away one of the justifications of the move.

An unofficial reason for the move was complaints from exporters that the Canadian dollar had become too strong, a strength which can be removed by interest rate cuts.

The Canadian dollar's strength was driven in part by the factor which has caused the U.S. dollar to fall against nearly all other currencies and in part because of the rising price of oil, a key Canadian export. At the same time, currency markets overlooked the negative effect of the U.S. recession on Canada's non-oil exports. Now as there has been a small oil price correction and as Bank of Canada in a bid to save non-oil exporters have cut interest rates, it is only logical that most of the Canadian dollar's gain have been wiped out.

I am fairly bearish on the Canadian dollar in the future too, at least relative to other currencies than the U.S. dollar. While I believe oil will soon recover from the correction of the latest week and that this will provide support for the Canadian dollar, the weakness of the U.S. economy will create strong downward pressure on it. Some 80% of Canada's exports and 25% of its GDP is exported to the U.S., and most of that is non-petroleum. Canada's non-petroleum exports will probably be hit hard by the U.S. recession. And Bank of Canada will probably continue to cut rates so that Canada's exports aren't also hurt by an increase in the Canadian dollar's value versus the U.S. dollar. Therefore, the Canadian dollar will probably be as weak or at least nearly as weak as its U.S. counterpart.


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