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Is loonie strength due merely to eagle weakness?

Ottawa, ON -- With the Canadian loonie flying alongside the American eagle, it is easy to forget that just 200 days...


Ottawa, ON — With the Canadian loonie flying alongside the American eagle, it is easy to forget that just 200 days ago the former was cruising 15 cents below the latter. How, exactly, did we get here?

There is certainly no shortage of explanations for the strong Canadian dollar. We are reminded that Canada has a trade surplus, a fiscal surplus, a strong consumer, high commodity prices, and incipient inflation pressures that point to the possibility of higher interest rates. All of these, and other factors, may play a role at one time or another in boosting the Canadian dollar.

And then there is the favourite explanation the weak U.S. dollar. There are also many reasons given for the recent decline in the U.S. dollar against most currencies: the trade deficit, the fiscal deficit, a softening consumer, high commodity prices, and a sub-prime mortgage market meltdown that has led to lower interest rates. In other words, many of the same global factors that make for a strong Canadian dollar tend to make for a soft U.S. dollar.

But interpreting the loonies move as due merely to U.S. dollar weakness is problematic. For one thing, we need to keep the U.S. dollars recent weakness in historical perspective. Measured against a basket of currencies, the U.S. dollar is about where it was in 1995. In between, it rose by about 25%, peaked in early 2002, and has since retraced its steps. Why? Because the world economy slowed and fell into a series of crises during 1997-2002, and has healed itself since.

Furthermore, the Canadian dollar has risen much more than the U.S. dollar has declined this year. The Canadian dollar has risen by 16% in nine months, from its level of 86 cents at the end of 2006. The U.S. dollar has declined only 5% against a basket of currencies in that time. The euro is up 7%, the yen 3%, sterling 3%, and the Australian dollar 11%.

Why has Canadas currency risen the most? First of all, the price of oil averaged around US$60 during the fourth quarter of 2006, and in recent weeks the price has been around $80. EDCs model of the Canadian dollar indicates that each $10 change in the price of oil causes a move in the Canadian dollar of 3 cents. Accordingly, oil can account for the rise in the Canadian dollar to around 92 cents; of course, those who believe that oil prices will keep rising, to $90 or $100, can use this argument to justify a level of the Canadian dollar as high as 95-98 cents.

Secondly, the U.S. economy is slowing and many believe that Canada will be largely untouched by this, adding upward momentum to the loonie. Whether the Canadian economy (and for that matter, the world) can remain immune to a U.S. slowdown remains to be seen. Recent export performance certainly suggests otherwise, but analysts who believe that the two economies have decoupled can use this argument to explain another 2-3 cents of the Canadian dollars rise.

The bottom line? Much of the loonies recent flight up to around 95 cents appears to have been driven by fundamentals. The remainder is more speculative in nature, propelled either by pure trading momentum or forecasts of even higher oil prices and continued strong growth in Canada an unlikely confluence of events.

Stephen S. Poloz is senior vice-president, corporate affairs and chief economist, Export Development Canada. EDC is a Crown Corporation that provides financing and risk management services to Canadian exporters and investors in up to 200 markets worldwide. The views expressed here are those of the author, and not necessarily of Export Development Canada. What’s your view on the loonie? Let us know at broebuck@mromagazine.com.