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January 8th 2011

Varied Forecasts for Canadian Dollar in 2011

The Canadian Dollar (“Loonie”) recorded a fairly strong 2010. It appreciated 5.5% against the US Dollar, as an encore to a 16% gain in 2009. Moreover, its rise occurred with remarkably little volatility, fluctuating within a tight range of $0.99 – $1.08 (CAD/USD. It total, it rose against “seven of its major peers,” and “gained 4.4 percent over the past year in a measure of 10 developed-nation currencies, Bloomberg Correlation-Weighted Currency Indexes showed.” As for 2011, it is expected to continue trading close to 1:1 against the USD, though analysts differ over which side of parity it will tend towards.

At the moment, there are a few key fundamental trends driving the Loonie. As the WSJ encapsulated, the first factor is investor risk tolerance: “The fortunes of the risk-sensitive Canadian dollar in 2011 will be determined in large part by the issues driving global market fluctuations.”  Due primarily to the EU sovereign debt crisis, risk appetite continues to experience dramatic ebbs and flows. Based on conventional wisdom, risk averse investors should incline towards shunning the Loonie in favor of the US Dollar and other safe haven currencies. However, if you track the Loonie’s actual performance, you can see that concerns over global financial instability have hardly impacted it. Thus, bulls see this uncertainty as a force that “pushes investors to diversify their foreign exchange holdings by picking up some Canadian dollars.”

The second set of factors are macroeconomic. While slowing slightly in the second half of the year, the Canadian economy nonetheless exhibited a solid performance, which is expected to continue into 2011. Goldman Sachs, for example, “now sees growth accelerating to 3.3 per cent in the second quarter of this year, and 3.5 per cent in both the third and fourth quarters amid improving domestic demand.” However, the strong performance by natural resources and Canadian export strength that drove growth in 2010 could also be interpreted as a wild card in 2011, as the trade surplus narrows from a moderation in commodities prices and an expensive Canadian Dollar.

Finally, there is the continuing search for “value currencies” that is driving investors towards the Loonie. According to Bill Gross, manager of the world’s biggest bond fund, “It’s a critical strategy going forward to get…into some currency that holds its value…I’d suggest Mexico, Brazil or Canada as three examples of countries with good fiscal balance sheets.” It doesn’t hurt that the Bank of Canada was the first G7 central bank to raise interest rates, and that its benchmark interest rate compares favorably with the US Dollar, Yen, etc. Moreover, it is forecast to hike rates by an additional 50 basis points in 2011, beginning in the third quarter. On the other hand, it will still be a couple years before rates are high enough to make carry trading viable. Besides, long-term interest rates are currently higher in the US, which means that investors hungry for yield will ultimately have to find other reasons for shifting funds to Canada.

Forecasts for the Canadian Dollar in 2011 are extremely varied. If there’s any consensus, it is that barring any unforeseen developments, the Loonie will spend the year close to parity with the US Dollar. A couple analysts expect a big (downside) move, but the majority expects that regardless of which way the Loonie ultimately trends, it probably won’t be far removed from current levels. “The Bloomberg composite of 32 forecasts has the loonie spending most of the year at parity, then dipping slightly by the fourth quarter.” A similar WSJ survey shows a median forecast of 1:1 throughout the entire year.

Some analysts expect more movement in the currency crosses (i.e. against currencies besides the US Dollar). Given that the Canadian Dollar accounts for such a small portion of overall forex trading volume, however, it seems more likely that CAD cross rates will take their cues entirely from the USD and the rule of triangular arbitrage. (For example, if the Dollar rises against the Loonie but falls against the Aussie in 2011, the Loonie will necessarily also fall against the Aussie, regardless of whether fundamentals dictate such a movie).

I’m personally inclined to agree with the majority. There are many good reasons to buy the Loonie, but most of these were already priced in during the Loonie’s steady climb over the last two years. Going forward, I think that the US economy represents a double-edged sword that will prevent the Loonie from rising further. In short, if the US economy falters, so will the Canadian economy. If the US economic recovery gathers momentum, however, there will be good reason to buy the US Dollar in lieu of its counterpart to the north.

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Posted by Adam Kritzer | in Canadian Dollar | 1 Comment »

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One Review of “Varied Forecasts for Canadian Dollar in 2011”

  1. Alex Borisov Says:

    US economy represents a double-edged sword – that’s for sure!

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