Health Check on the Canadian Dollar

November 29, 2021 | Jonathan Yung


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How to Analyze Currency Valuations

This week I would like to share some perspectives about where our Canadian dollar sits against the US Dollar (USD), both technically and fundamentally. During the early part of May, the Canadian dollar reached a high of 0.8389 against the USD and has since then weakened to a low of 0.772 in August. This week, it has been sitting at around 0.79 to 0.80. We continually watch currency movements as it has the ability to impact one’s portfolio returns. After all, the returns on a US listed stock will be increased or reduced by the performance of the USD.

Looking at Currency Using Technicals

When looking at the technical chart below, one can see that the 0.68-0.69 lows of 2016 could be interpreted as a key longer-term support level for the future. A support level is a point or range where it appears that prices have resisted breaking down below. Rather, buyers seem to come in at these levels to “hold the line”, which then helps the trend to reverse and bounce higher. When prices revisit these lows at a later time, we refer to this as a ‘retest’. The ability to bounce higher again serves to strengthen one’s case that there is support at those specific levels.

RBC Wealth Management uses the chart below to highlight other key levels to watch out for. In their view, a bounce back to the recent top of 0.83 should be where the loonie consolidates to in Q4, with 0.77 likely defining the lows for the rest of 2021.  Should the loonie rise above 0.84, the next hurdle higher is 0.87 followed by the next resistance at 0.91.

Looking at Currency Using Fundamentals

There are many models that aim to assist in determining the fair value of our Canadian dollar against USD. Although it may be beyond the purview of clients to track a seemingly infinite amount of currency-moving variables, Scotiabank Global Economics has developed a model that uses four key fundamental pillars. We believe these variables can help all investors to develop a proper framework when thinking about currencies.

Skipping to the conclusion, this model currently suggests that the USD/CAD exchange rate is currently overvalued by ~2% at a fair value of 1.22 USD per CAD or 0.8197 CAD per USD. This implies that the Canadian dollar has room to further strengthen. Those inclined to learn further about the specific variables used in the model may read further below.

Commodity Prices (Oil and Metals)

Over the past few decades, Canada has held a trade surplus with the US in petroleum products. This has historically resulted in a high correlation between oil prices and the demand for the Canadian dollar. Although crude oil production in the US has grown and the country’s dependence on foreign oil has decreased, this correlation between the Canadian Dollar and commodity prices has stayed intact.  The charts below suggests that the gains in oil and metals prices have outpaced the loonie, and therefore the Canadian dollar may have further upside.

Interest Rate Spreads

Higher interest rates from Canadian assets relative to US assets should intuitively increase demand for the Canadian dollar as investors seek higher yields. Short-term 2-year spreads between Canada and US tend to reflect near-term interest rate expectations while 5-year spreads can provide clues to the pace at which the two central banks may change rates relative to one another.  Historically, the direction of the spread has been correlated to the value of the Canadian dollar. As the charts below show, the spreads appear to be increasing which suggests further upside for CAD.

Volatility

Market risk sentiment can be evaluated using the CBOE’s volatility index (VIX). Higher levels of volatility reflects greater anxiety in the financial markets. Historically, as the VIX has risen, the USD has typically outperformed as global investors seek safety from holding the world’s largest reserve currency. As the chart below shows, the VIX has gradually fallen as the uncertainty surrounding the COVID pandemic wanes and consumers look towards an economic recovery. This could suggest that fewer investors need to seek shelter in the USD and therefore the CAD could strengthen.

The USD Effective Exchange Rate

This final pillar of the model looks at a variety of relationships within a broader dollar index.  This takes into consideration multilateral adjustments from different economic and financial conditions that impact the demand for USD. This includes factors like the country’s trade balance, relative return on assets, and the volatility of the currency. These help establish a long-run equilibrium exchange rate. As the chart below shows, the USD effective exchange rate has fallen relative to the previous COVID highs and appears to be firming at the current levels that support a strong Canadian Dollar.

Although currency forecasts are hard to make, RBC Wealth Management and Scotiabank Economics appear to suggest that both technicals and fundamentals point to an undervalued Canadian dollar that has the potential to move higher against the US Dollar. In our opinion, the undervaluation appears nominal at 2% and therefore we would not be inclined to make drastic geographic mix changes based on currency reasons alone. Of course, currency can be unpredictable and some investors may seek to hedge out this currency risk either partially or fully from their portfolio. Investors should speak to their advisor to discuss how their portfolio has been affected in the past by currency movements and what currency volatility management solutions could be implemented.

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