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Canada's exchange rate -- beyond parity in 2011

Scotia Capital’s monthly foreign exchange strategy conference call is a great piece of research.  Sutton and Tihanyi do an excellent job on providing both S/T and L/T flavor to the foreign exchange market.  When Canadians talk foreign exchange they talk about the US Dollar, since the vast majority of Canada’s trade flows are with the U.S.

Scotia Capital’s thesis is that over the next 18 months:
(1)               The Canadian dollar will settle slightly over parity with the US dollar, and
(2)               That Canadian short term interest rates will range around 2.25%.

According to Scotia Capital, the factors with the highest level of correlation with a stronger Canadian dollar are:

(1)               Performance of the S&P 500
(2)               Oil Prices
(3)               Direction of the Euro
(4)               Copper prices

In terms of negative correlation the US S&P 500 volatility index presents an almost perfect correlation of -0.95

According to Scotia Capital, the drivers for higher interest rates are inflation and a recovering domestic economy. Interest rates at 0.5% are too accommodative, since real interest rate is now -1.5% (0.5% less 2.0% inflation).  However, despite a broad recovery our economy remains subject to external shocks.  Although housing was the dominant GDP driver over the past 12 months it is now falling back.  The March 2010 GDP growth sources were very well diversified with manufacturing (which had been lagging in the pervious 12 months), mining and energy, wholesale and agriculture.  

Scotia Capital is in the same crowd that believes that interest rates differential between the U.S. and Canada will exceed 0.75% by the end of the year.  However, this is not a sure thing as the Governor of the Bank of Canada said on June 16th: 

While “[r]ecent activity in Canada is unfolding largely as expected”, Mr. Carney emphasized that the “outlook is subject to considerable uncertainties. In most advanced economies, the recovery remains heavily dependent on monetary and fiscal stimulus.” Perhaps the key comment, which is not new, is that “[i]n light of the scale and volatility of these conflicting forces, it should be evident that no particular path for monetary policy is preordained

Part of the problem for the Bank of Canada is that the U.S. is a fiscal mess.  The numbers are daunting. 





The risk then becomes that Canada falls off a cliff because of the neighborhood!

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