Sometimes I wonder if I’m living in the clouds. All of my
recent reports on the Canadian dollar
were twinged with pessimism, and I argued that it would only be a
matter of time before reality caught up with theory. While the
continued surge in commodities prices has confounded everyone’s
expectations, other economic trends continue to work against Canada. In
other words, I think that there is still a strong argument to be made
for shorting the loonie.

To be sure, the rally in commodities prices has been incredible-
nearly 50% in less than a year! Oil prices are surging, gold prices
just touched a record high, and a string of natural disasters have
driven prices for agricultural staples to stratospheric levels. Given
the perception of the Canadian dollar as a commodity currency, then,
it’s no wonder that rising commodity prices have translated into a
stronger currency.
As I’ve argued previously, rising commodities prices are basically an
irrelevant – or even distracting – factor when it comes to analyzing
the loonie. That’s because, contrary to popular belief, commodities
represent an almost negligible component of Canada’s economy. Canadian
exports, of which commodities probably account for half, have recovered
from the recession lows of 2009. On the other hand, the value of
Canadian exports is basically the same as it was 10 years ago, when one
US dollar could be exchanged for 1.5 Canadian dollars.

Consider
also that Canada now imports more than it exports, and that the
Canadian balance of trade recently dipped into deficit for the first
time since records started being kept 40 years ago. Its current account
has similarly plunged, as Canadians have had to finance this through
loans and investment capital from abroad. Based on the expenditure
approach to GDP, trade actually detracts from Canadian GDP. Any way you
perform the calculations, commodities are hardly the backbone of its
economy, account for about 15% at most.

As if that weren’t enough, the press is full of stories of Canadians that think their own currency is overvalued.
Businesses complain
that they can’t compete, and that banks won’t lend them the money they
need to upgrade their facilities and become more efficient. Meanwhile
consumers whine about higher prices in Canada, compared to the US. I
think it’s very telling that there is now a
2-hour wait to cross the border from Vancouver, and shopping malls on the American side have reported a huge jump in business. Even the famous
Big Mac Index
shows that the price of a hamburger was already 12% higher in Canada
back when the loonie was still hovering around parity with the US
Dollar.
One area that higher commodities prices will be felt is inflation,
which is nearing a two-year high and rising. At 3.3%, Canada’s CPI rate
is now higher than in the EU. Given that the European Central Bank
hiked rates earlier this month, it probably won’t be long before the
Bank of Canada follows suit. In fact,
forecasters expect the benchmark rate to rise by 50-75 basis points by the end of the year, from the current 1%.
This might excite carry traders, but probably few others. Besides,
given that other central banks will probably raise rates concurrently,
it can’t be assumed that carry traders will automatically gravitate
towards the Canadian dollar. Not to mention that as I pointed out in my
previous post,
the carry trade is hardly a risk-free proposition. In this case, an
interest rate differential of only 1-2% probably isn’t enough to
compensate for the risk of a correction in the USD/CAD.
And that is exactly what I expect will happen. The fact that the
loonie has shattered even the most optimistic forecasts is not cause
for bullishness, but rather for concern. According to the most recent
Commitment of Traders report, net long positions are reaching extreme levels, and it’s probably only a matter of time before the loonie returns to earth.
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