Economic & Market Update – Week of December 9th, 2022 – Loonie Outlook
This week we will take a deeper dive into the Canadian dollar and discuss our thoughts on the outlook for 2023 and beyond.
Let’s dive in with a chart of CAD/USD and add oil prices just for fun:
Here we are looking at the past 20-years for CAD/USD. 2002 to 2012 saw a massive rally in CAD, which was briefly interrupted by the Global Financial Crisis, but otherwise saw CAD go from the low $0.60’s to north of par. We would note during this period that oil prices rose from ~$20/boe to ~$140/boe and it was not hard to see from the chart that there was a seemingly very strong relationship between oil prices and the Canadian dollar.
Now, we can also see from the chart that around 2012, the relationship between CAD and oil seems to breakdown. Certainly not completely, as sharp dips in the price of oil do seem to match sharp dips in CAD (although, the magnitude of CAD declines are less pronounced), but the price of oil does appear to become less important to the ebbs and flows of CAD/USD. Why?
The why is actually pretty straightforward:
- U.S. oil production, which had been in decline for the better part of 40-years, suddenly began to ramp up around 2012. This was largely the result of new technology, which allowed for previously known reserves of shale oil (essentially oil encased in rock) to be economically extracted from the ground
As you can see from the chart, the U.S., which was stuck at around five-million barrels of daily production, saw its production rise to ~13-million boe/day leading up to COVID. This increased U.S. production (about eight million daily barrels) is roughly the equivalent of two Canadas (Canada produces about 4.5 million boe/day). So, in a sense, Canadian oil became less important because U.S. production replaced it. Now, this is not the sole reason why the CAD/oil relationship broke down, but it is part of it.
2. The Investment Canada Act – remember Potash Corporation of Saskatchewan? If you don’t, it’s okay, but about 12 or so years ago, BHP, which is a multi-national mining conglomerate, tried to buy Potash Corp., which was the world’s largest miner of potash at the time. The government of Canada said no and subsequently changed the Investment Canada Act, making it much more difficult for foreign investors to purchase or invest in Canadian assets. Add to this a myriad of rules and regulations both at the provincial and federal levels and the general appetite for foreign investment in Canada has declined – especially as it relates to oil and gas.
Tying these two together, Canadian oil becomes less important because of the surge in U.S. production at the same time that the foreign appetite for investing in Canada declines. In the past (pre-2012), when oil prices rose it tended to drive significant new investment in Canada in terms of new project development. These new projects drew in foreign investment, which increased foreign demand for Canadian dollars (if you are going to invest in Canadian projects and assets, you need Canadian dollars to do it), which in turn led to strength in CAD. Today, high oil prices do not tend to attract foreign investment (or domestic investment for that matter), so the relationship to CAD has weakened significantly.
In chart form, it looks like this:
Outlook – relative rates and risk on/risk off
While the above is more of a history lesson, what will matter more to CAD/USD from here are relative rates and risk on/risk off.
- Relative rates is simply the amount of interest one can earn on government bonds in one country vs. the other. Let’s look at a chart of Canada vs. the U.S. and then comment:
Here, we are looking at rates on government bonds from 1-month all the way out to 30-years. As you can see, with the exception of the very short-term, rates in the U.S. are higher than they are in Canada, which should benefit the U.S. dollar all else equal. We would add to this the likelihood that the U.S. Federal Reserve will continue to raise rates into early 2023, while the BoC is probably close to ending its rate hiking cycle, further driving a divergence in rates.
- Risk on/risk off – In many ways, the Canadian dollar has become a proxy for risk-taking in the markets. When investors are feeling frisky, CAD will tend to strengthen, while when investors are feeling fearful, CAD will tend to weaken. We would note that Canada is not unique in this respect as it is more of a commentary on the U.S. dollar vs. other currencies (USD strengthens on fear and weakens on, err, “frisk”). Post-COVID and into late 2021, CAD and most other global currencies did well as markets were in risk-on mode, whereas 2022 has seen the opposite.
So, where does that leave our outlook? We think 2023 is likely to be bumpy with the early part of the year potentially containing some significant challenges (we will get into more detail on this in our 2023 Look-Ahead). Thus, we think risk-off is likely to prevail, which will keep a lid on CAD, probably in the ~$0.70 to ~$0.78 range with a bias to the lower end of the range. Add to this the likelihood that U.S. interest rates will remain elevated and we think a significant upside breakout in CAD (say to north of $0.80) is low.