October 9th, 2007

 

Blurb: During the past five years the Canadian dollar has skyrocketed in value. But is the loonie due for a correction?

 

Where will the Canadian dollar go next?

 

By Peter Diekmeyer • Bankrate.com

 

A new word has recently entered the lexicon of many Canadians: parity. That’s right, during recent weeks the loonie has been trading at above the U.S. $1.00 level for the first time in more than 30 years. The most recent surge caps a five-year stretch that has seen the loonie climb by close to 60 percent relative to the greenback.

 

The Canadian currency’s current strength is good news for people who buy imported goods and travel south of the border as well as for businesses and other investors who purchase U.S. assets or property. On the other hand, Canadian exporters, particularly manufacturers, are facing serious competitiveness challenges.

 

Experts say that Canadians had better get adjusted to the new reality, because the loonie could stay strong for quite some time. “The Canadian dollar’s strength is backed by strong fundamentals,” says Yannick Desnoyers, a senior economist with National Bank Financial. “But it is also a reflection of how poorly things are going in the United States.”

 

A somewhat surprising surge

The loonie’s recent surge has caught many people by surprise. In fact not so long ago some economists were predicting that our dollar would fall to U.S. $0.60 and that Canadians would be forced to one day accept a monetary union with our southern partners.

 

There are several reasons for the Canadian dollar’s recent strength. While many would like to ascribe it to our competitive genius and hard work, that’s wishful thinking. Currency markets regard the loonie, like the Australian dollar and the New Zealand Kiwi, as a resources-based currency, which rises and falls based on world prices for the commodities that we dig out of our land.

 

In short, much of the loonie’s recent success is due to our rear ends, or rather to the oil, natural gas, diamonds, gold and nickel that they are sitting on, all of which have been in great demand in recent years, particularly by rising Asian economies such as India and China.

 

But commodities don’t tell the whole story. In fact much of the loonie’s recent strength is also due to weak fundamentals underlying the U.S. economy. Growth south of the border during the first half of the year ran at less than 2.0 percent compared to 3.5 percent here in Canada. Furthermore U.S. consumer confidence has slowed and consumption will likely follow suit.

 

If the loonie stays this high…

The implications of a stronger Canadian dollar are profound. The good news is that most of the commodities that we sell are priced in U.S. dollars. When the greenback falls, these commodities rise in value by a corresponding amount, so we are not affected on that count.

 

However for Canadians that work in export-related businesses such as Ontario’s auto industry, it’s a different story. Car companies are constantly comparing the hourly cost of Canadian and U.S. workers. Since most of these companies reports earnings in greenbacks, any rise in the loonie increases the relative costs for them of doing business here. So it is not surprising, that Canada’s manufacturing sector, much of which is located in Quebec and Ontario has been hit quite hard in recent years.

 

The other area in which we will likely see increased movement is in cross border shopping. A couple of weeks ago we reported that Canadian businesses were being a little slow in passing on the savings that they were reaping from the stronger loonie on to consumers. At the time, the loonie was trading in U.S. $0.95 range. Since then it has shot up by close to six cents. A move that strong will only increase Canadians’ desire to head south for some weekend shopping -- no matter how long those border lineups are.

 

So how long will the good times last?

A strong currency is by and large a good thing for a country. So Canadians should enjoy the good times while they last. The real question is just how long that will be.

 

One concern is the fact that the loonie is currently trading at far above its purchasing power parity (PPP) level relative to the U.S. dollar. PPP is a rough economic measure of the size of a basket of goods that can be bought with a specific amount of both currencies in their own respective countries. PPP values are a key indicator to watch because they are generally considered to be an indicator of a currency’s long term equilibrium value.

 

According to Desnoyers, another factor has been the rapidly of the loonie’s recent upsurge. “The Canadian dollar rose by close to 16 percent since the start of the year, which is a very abrupt move,” says Desnoyers. “Much of what occurs will depend on what happens to U.S. monetary policy and more precisely to the differential between Canadian and American interest rates.”

 

The good news is that the last time the Canadian dollar traded at near parity with the greenback it did so for several years. This should be a warning sign for those who are considering betting against the loonie, just because it is trading above its PPP value. It brings to mind an old saying about the markets: “People can remain illogical much longer than you can remain solvent.”

 

Peter Diekmeyer (www.peterdiekmeyer.com) is a freelance business and economics writer.

 

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