The loonie

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   By Guest Blogger Ryan Lewenza

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The US dollar has been given the moniker ‘king dollar’ as it is the world’s reserve currency that powers much of the global economy. That nickname definitely rings true for this year with the US dollar up against every major currency around the world.

Below is a chart showing the US dollar appreciation versus all the major global currencies for this year. For example, the US dollar us up 1.6% versus the British Pound and up 10% versus the Japanese Yen. Driving the Yankee dollar higher is the sticky US inflation, which is causing the Federal Reserve (Fed) to push out the expected rate cuts for this year.

In the beginning of the year the bond market was pricing in six rate cuts (we said this was a pipe dream), and now the bond market is pricing in just a few cuts later this year as US inflation has remained well above the Fed’s 2% inflation target.

The prospect of higher US interest rates, and concerns around our out-of-control government spending and deficits, have weighed on our Canadian dollar with the loonie down 3.4% this year. With the recent weakness in our dollar, it’s brought out some bears with one highly regarded portfolio manager making a bold prediction that the loonie could fall to 50 cents in the coming years if things don’t change.

Yes, the near-term outlook for the Canadian dollar looks challenging but I don’t see our dollar declining any where near 50 cents and, in fact, see the potential for the Canadian dollar to rebound over the next 12-18 months.

Global currencies y-t-d performance vs the USD

Source: The New York Times

Some years back when I was the Chief Strategist for Raymond James, I did an exhaustive study trying to determine the main drivers of the Canadian dollar. I compared the Canadian the dollar to a number of different economic and market indicators and found that the two main indicators/drivers of the CAD/USD are: 1) commodity and oil prices, and 2) the interest rate differential between Canadian and US bonds.

Let’s examine these two drivers to see what they could portend for the Canadian dollar in the coming months.

First, commodity and oil prices have been doing quite well this year, which is generally bullish for our dollar. For example, US oil prices (WTI) are up 10% so far this year, while copper prices have been on a tear, up over 15%.

As seen below, the CAD/USD dollar tends to track oil prices pretty closely over time. Going back all the way to 1994, there has been a 0.80 correlation between the CAD/USD and oil prices, so oil/commodity prices do play a role in our dollar. More recently, we’ve seen this correlation decline so the current high oil prices are not having as much of an impact on our loonie.

These correlations are not static or fixed. They change over time as we’re seeing right now, but I continue to believe oil and commodity prices will remain important drivers of our loonie over the long run. And, given I’m bullish on commodity prices over the next few years this should help our dollar, and we could see our dollar rebound over the next year.

Canadian dollar and oil prices

Source: Bloomberg, Turner Investments

Second, the spread or interest rate differential between Canadian and US bond yields are an important driver of the CAD/USD and right now, this is negative for our loonie. It looks all but certain that the Bank of Canada (BoC) will cut interest rates in the coming months. Our economy has stalled out, inflation in Canada has slowed more than in the US, and there is an estimated 80% of all outstanding mortgages as of March 2022 that are coming up for renewal in 2024. I believe these factors will push the BoC to begin cutting interest rates this year, potentially as early as their June meeting.

In contrast, the US economy is performing much better, inflation is running hotter in the US and given that US mortgages are much longer in length (30 years), I don’t see the Fed in such a rush to cut interest rates. More likely we’re looking at cuts later this year.

If the BoC begins cutting rates before the Fed, Canadian bond yields will decline relative to US bond yields, and this would be negative for our Canadian dollar. I illustrate this in the chart below. The chart overlays the CAD/USD currency with the difference in 2-year interest rates between Canadian and US government bonds. Essentially, when interest rates are higher in the US than in Canada, as is the case at present, then this tends to be negative for our dollar and a big reason why the Canadian dollar has dropped this year.

CAD/USD rate with CAD/USD interest rate differential

Source: Bloomberg, Turner Investments

So, we have two main drivers for the Canadian dollar with one negative (interest rates) and one positive (commodity prices). Currently, the CAD/USD sits around 73 cents and it could drop a few more pennies if/when the BoC starts to cut rates. Maybe it bottoms out in the low 70s this year. But, given my positive outlook for oil and commodity prices, and that the Fed will cut rates inevitably, the Canadian dollar could rebound later this year and into 2025.

I wrote a blog on the loonie a few years back and predicted the CAD/USD would trade rangebound between roughly 70 and 80 cents, and this forecast has proved to be accurate. I continue to hold this view and therefore recommend investors trim their US dollar holdings when the CAD is in the low 70s and buy US dollars with CAD when the CAD is high around the 80s level.

Here at Turner Investments we’re watching the loonie closely and we may look to reduce (sell) some of our US dollar exposure if it dips into the low 70s as I don’t see it getting much below this level and definitely not falling all the way down to 50 cents.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Investment Advisor, Private Client Group, of Raymond James Ltd.