by Hubert Marleau, Market Economist, Palos Management
For the year ended November 30, 2019 the exchange value of the Canadian dollar has been stuck in a box, trading between a low of 74.50 and 76.25 U.S. cents. It is remarkable that there has not been more volatility. Looking at the implied volatility, the Canadian dollar as an asset class hasn’t been calm for years.
Despite the relative small size of the Canadian economy, the forex market for the Loonie is heavily traded and very liquid against the Greenback. The amount of commerce, travelling and investments that take place between the two countries is proportionally large and it keeps growing, resulting in a multitude of pair trades. The sheer liquidity has the effect of preventing sudden stops or extreme moves.
Given the vast sums of money changing hands every day between Canada and the U.S., I’m very preoccupied with the recipe used in the currency dealing rooms of North American banks. Many have asked me how the foreign exchange market can be so calm at such a turbulent juncture for global trade and political developments. The main explanation for low turbulence is that the Canadian dollar has a central tendency to trade near its Purchasing Power Parity Rate which around 80 US cents. Actually, two forces govern this universe: one is fundamental and the other is technical.
Technical analysis is used a lot by traders to identify patterns in market movements in order to predict future price changes and develop trading strategies for profit. Technically, the value of the Loonie has been stalled below the point where it ought to trade. That is because the emotional narrative about the CND$ is bearish and a continuation of this phenomenon seems likely. Market interpreters have negative views about the politics of the Canada and the indecisiveness of its people.
It’s consistently reflected in the laundry list of reasons why in the editorial pages of the media Canada will underperform. One has only to focus on the signal that the Canadian bond market is sending. Canada is the only country in the world with an inverted yield curve. That makes bad press viral. Yet, I contacted several technical analysts over the weekend. There is a consensus that the Loonie is bottoming out, has built a solid foundation over the last three years and outperformance is pending. A currency strategist told me that “a catalyst is needed to spark a new trend when you have just had a long period of low volatility and consolidation.”
Evaluating the view of market pundits predicting that the Loonie will fall further against the odds that such an outcome will not occur makes me nervous. In my judgment, the foreign exchange markets have already priced in the aforementioned narrative. The Loonie is trading for four cents less than its purchasing power parity rate. It should be understood that this game is much more emotional than commonly believed. It’s not about what will happen in the absolute sense, but what will happen versus what is already discounted. In this connection, I might be blindly optimistic on Canada, but one must take into consideration that there could be several catalytic surprises in the offing.
Indeed, the tide could turn if one of the three forces that fundamentally drive the standard model which traders rely on to make their bets. The three factors are monetary policy, terms of trade and foreign capital.
- As a rule, Canada attracts enough foreign capital to cover its current account deficit. In the first nine month of 2019, the current account deficit totalled $33.4 billion while non-resident investors grew their net positions in Canadian financial securities by $38.6 billion. There is a better than a 50% chance that foreigners could up their investments in Canadian equities. Equity risk premiums and earning yields are much higher in Canada than in the U.S. Meanwhile the Loonie is undervalued. Foreign exchange adjusted, the TSX index is 4.1 times the S&P 500--that is an historical low. None of the business lines in Canada are toppish--on the contrary most have been consolidating. Meanwhile, a lot of foreign money is parked in Canadian banks by international investors which may be waiting for uncertainties about the USMCA and regulations in the energy sector to dissipate and by the huge influx of new immigrants wanting to invest in the real estate market.
- The Canadian economy slowed in Q/3. It grew at an annual rate of 1.3%, down from a revised 3.5% pace in Q/2. However, the details of the GDP report were encouraging. The drag was the larger trade deficit and the weaker accumulation of business inventories. Healthy gains were registered in final domestic demand because of a boost in business investments and the resilience of residential construction. Consumer spending on goods and services held, modestly rising 1.6%. Thus, the Bank of Canada must be pleased with where interest rates are. Canada’s economy is in better shape than first thought as the output gap suddenly looks a lot smaller. Consequently, the monetary stance between Canada and the U.S. is likely to diverge in our favour for the first time in a year because the Bank of Canada does not need to add more monetary stimulus. The Bank of Canada is tough. It did not wet itself when the yield curve inverted last summer. Why would I short a currency of a country whose central bank--the only in the world-- does not think QE is the solution to arrest weakening growth? In contrast, the Fed is embracing QE another time. There is empirical evidence and theoretical validity that when a central bank holds the line when the economic and financial numbers dictate otherwise---the currency rises.
- Canadian terms of trade are negatively affected by low commodity prices--particularly oil and gas which are big exporters. Oil prices are stuck in the mud and out of favour even though global demand is still rising at a time when the oil industry is emphasizing capital discipline. Unless global demand is about to fall off a cliff, there won’t be enough oil and gas to meet mid-term demand--very soon. Energy could surprise and emerge as scarce resources. WTI crude oil net long positions are at level that have coincided with a through in oil prices in the past years, perhaps signalling that OPEC+ may consider deeper production cuts. Yale endowment chief David Swensen said in the weekend Barron: “If we stopped producing fossil fuels, we would all die...The real problem is the consumption of fossil fuels, and every one of us in the room is a consumer. And I guess it’s a little harder to look in the mirror and say, I’m part of the problem.”
P.S. The idea of “SELLING THE LOONIE AGAINST EVERYTHING” was pushed back by Louis Gave of Gavekal Research--a very reputable international macro thinker. I share his opinion that Canada would be a major benefactor of the coming inflationary pulse. I happen to agree with him that the market is massively complacent about inflation. As things stand the real risk to the financial markets is inflation. So, why would I want to be short a commodity currency with the Queen’s head on it like the Loonie. Louis ends with the punt: “I’ll leave you the green stuff.”
Copyright © Palos Management
