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CIBC World Markets Inc.
Economic Insights—June 25, 2015
Rich Loonie to Slow Poloz
Nick Exarhos and Avery Shenfeld
Oil’s tumble has brought the Canadian dollar down
with it. But our currency is still richer than it may look.
A careful analysis of macro linkages suggests that, when
adjusted for the deterioration in trade fundamentals and
rate spreads, the currency is posing a meaningful drag on
growth. That’s tantamount to tighter overall monetary
conditions than are conveyed by looking at interest rates
in isolation. Look for overall monetary conditions to be
brought into better alignment as the Fed hikes and the
Bank of Canada stands pat, allowing the loonie to stay
grounded even as oil recovers.
A main driver of that movement in favour of the value
of Canadian exports was robust energy prices. However,
when comparing the time before and after the Great
Recession, it took less from oil for the Canadian dollar
to trade near, and through, parity versus the greenback
(Chart 1, right). Furthermore, the loonie’s resiliency was
even more impressive since non-oil commodity prices
were also weaker post crisis—namely lumber, natural
gas, and most metals—while the C$ traded through prior
cycle highs. That suggests that even when accounting
for the strength of commodity prices, including oil, other
factors were at play in lifting the currency, including safe
haven flows during, and in the aftermath of, the financial
crisis.
Canada: A Currency Sensitive Nation
Canada is one of the most open G7 economies, with its
30% share of exports to GDP second only to Germany.
And while Germany sends its outbound shipments largely
within the Eurozone, making it less sensitive to currency
fluctuations, Canada benefits from no such buffer. That’s
why the competitiveness of our non-resource exports is
particularly vulnerable to the strength in the Canadian
dollar. The loonie was powered by the most dramatic,
positive terms of trade shock amongst the G7 (Chart
1, left) since 2005, when OECD estimates placed the
Canadian dollar at fair value.
A symptom of the deviation from fundamentals can be
seen in the trade data. Though oil prices held onto levels
that were not that far from the pre-recession peaks, the
Canadian trade balance was a few billion dollars lower
than it was before (Chart 2, left). That deterioration
was primarily led by the ex-energy balance, which has
been on average $6 billion dollars weaker in the current
recovery (Chart 2, right). While Canadian GDP held
its own relatively well through that period—especially
compared to some of the weaker G7 members—it leaned
heavily on housing and debt-financed consumption. And
we know that those trends won’t go on forever.
Chart 1
Chart 2
CDA Experienced Positive Terms of Trade Shock (L);
But Less Required From WTI for Higher Altitude (R)
Trade Balance in Red Despite Higher Crude (L);
Driven by Non-Energy Deterioration (R)
$/bbl
100
95
85
90
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
75
Cda
Japan
Ger
USA
100
4
80
2
0
60
0
40
-2
-1
20
-4
Pre-Crisis
WTI (US$/bbl, L)
Trade Bal ($ bn, R)
Post-Crisis
Source: OECD, Bloomberg, CIBC
2
Non-Energy Trade Balance
(monthly avg, C$ bn)
1
-2
-6 -3
0
85
80
6
Jan-00
80
120
Jul-13
90
8
Jan-09
95
140
Apr-11
100
10
Oct-06
105
105
160
Jul-04
110
Avg WTI Price
When C$>95 US-cents
Apr-02
Terms of Trade (2005=100)
115
-4
-5
-6
'00-'08
'09-Today
Source: Statistics Canada, CIBC
3
CIBC World Markets Inc.
Economic Insights—June 25, 2015
How Rich is the Loonie?
Chart 4
Rich Loonie Equivalent to Tighter BoC Policy
In an effort to uncover what “fair value” would be for
the Canadian dollar given underlying drivers, we’ve
constructed a regression model incorporating energy
prices, non-energy commodity prices and interest rate
spreads. Other popular methods use error-correction
models, which try to measure the dynamics of the C$’s
trading, and how quickly the currency re-establishes the
short-run equilibrium. Our model instead derives a fair
value on the currency given its historical relationship
with its underlying drivers, on a real basis. The analysis
suggests that since 2009, the C$ has been trading
roughly 10% rich versus fundamentals since the end of
the recession (Chart 3).
Bank of Canada
Avg Overnight Rate (%)
7
6
5
4
~90 bps tighter
3
2
1
0
Q1-00
Q3-02
Q1-05
Q3-07
Q1-10
Actual
Q3-12
Q1-15
Equivalent
Source: BoC, CIBC
Given that Canadian growth is in part driven by the
interest rate setting, and in part due to the exchange
rate (especially since Canada is an open economy),
we can determine output sensitivities to both those
factors. As we model Canadian aggregate demand using
interest rates and the Canadian dollar, we can establish
the tradeoff between an overvaluation in the currency
and the equivalent boost to the overnight rate. We
also measured the sensitivity of growth to both interest
rates and the degree to which the Canadian dollar was
overvalued due to exogenous factors.
the currency to the overnight rate, which would have
suggested a dramatic 3% lift to the monetary setting.
Given that we spent over 70% of the time since 2009
with core CPI under 2%, it shouldn’t be a huge surprise
that our analysis suggests that monetary conditions have
been tighter than the BoC’s official rate.
In an effort to keep the Canadian dollar trading well
beneath parity, while at the same time counteracting
the implied effects on monetary policy that the currency
has provided, expect the BoC to be much more patient
than the Fed, with short end rate spreads between the
two nations closing (Chart 5, left). A less turbulent global
environment, along with the elimination of the short rate
advantage will cause the premium placed on the C$ to
also narrow significantly by the end of 2016 (Chart 5,
right).
Taken together, those models imply that the loonie’s
richness was equivalent to roughly 90 bps of tighter
BoC policy since the start of 2009 (Chart 4). That’s lower
than what we would have estimated using the Bank of
Canada’s once widely used monetary conditions index.
The BoC’s index had a roughly 3 to 1 tradeoff between
Chart 3
Chart 5
CIBC Fair Value Model Points To Significant C$
Overvaluation
BoC Will Lag Fed (L), Helping Premium Dissipate
from Currency (R)
Difference in Effective
O/N Rates (Can-US, bps)
100
fcst
80
60
Mar-16
Sep-16
Mar-15
Sep-15
Sep-14
Jun-16
Dec-14
Sep-15
Jun-13
Mar-14
Dec-11
Sep-12
Mar-11
Mar-14
70
-20
4
90
75
0
Source: Bloomberg, Statistics Canada, CIBC
fcst
95
80
20
CIBC Model
US-cents/C$
100
85
40
CADUSD
105
Mar-13
Avg 9.5% Overvaluation
Sep-13
US-cents/C$
Mar-01
Dec-01
Sep-02
Jun-03
Mar-04
Dec-04
Sep-05
Jun-06
Mar-07
Dec-07
Sep-08
Jun-09
Mar-10
Dec-10
Sep-11
Jun-12
Mar-13
Dec-13
Sep-14
110
105
100
95
90
85
80
75
70
65
60
CADUSD
CIBC Model
Source: Bloomberg, CIBC