The loonie

   By Guest Blogger Ryan Lewenza

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The four most common questions I receive from clients are: 1) will the equity markets and my portfolio be up this year; 2) how I can pay less in taxes; 3) how do you maintain your boyish good looks and chiseled abs when you’re so busy looking after clients; and 4) where is the Canadian dollar headed. I look forward to the thrashing I’ll receive on the third question in the comments section but today I’ll address the last question on where the Canadian dollar is headed.

The Canadian dollar has been on a tear! Since bottoming around 69 cents to the US dollar last March, it’s rallied over 15% to roughly 80 cents currently. The strength in the Canadian dollar can be attributed to a few key factors.

First, oil prices have come back strongly since going negative for a day last March (that’s one for the books!). Second, the Bank of Canada (BoC) has announced that it will start winding down its emergency bond buying program in the coming months, being the first major central bank to end these emergency programs. And third, general weakness in the US dollar versus most currencies with the Federal Reserve keeping the ‘pedal to the metal’ by continuing to inject massive sums of monetary stimulus through their bond buying programs.

But stepping back the Canadian dollar has been largely range-bound for over six years now. Since oil prices collapsed from over $100/bl in 2014 it has taken the Canadian dollar down with it, falling from par or $1 to a low of $0.685 in 2016 (there was a re-test of these lows in March of last year). So from the chart below you can see the CAD has been range-bound between roughly $0.70 (technical support) and $0.80 cents (technical resistance).

Question then is: is the CAD on the verge of a big breakout or is it set for more range-bound trading?

Canadian Dollar Has Been Range-bound for Years

Source: Stockcharts, Turner Investments

Let’s start with oil prices.

While there are times when the relationship between the Canadian dollar and oil prices will disconnect or weaken, over the longhaul, oil prices still play a prominent role in where our dollar goes. As oil prices have come roaring back, in large part, due to expectations for higher demand when we get control of Covid, this has helped to drive our dollar higher as well.

Last year I predicted that oil prices would recover back to $60/bl where we currently stand. I’m getting more bullish on commodities as demand and inflation pick up (commodities do well in an inflationary environment) so we could see oil prices move a bit higher (possibly hit $70/bl this year), but I do not see oil prices hitting $90-100/bl any time soon so upside is fairly limited from here. As such, this should help to limit further upside in the Canadian dollar.

CAD Strongly Correlates With Oil Prices

Source: Bloomberg, Turner Investments

Next up is the ‘interest rate differential’ or the difference in government bond yields between Canada and the US. If our interest rates are higher than the US (as they are currently) then this is bullish for the Canadian dollar.

With the BoC announcing that it will be winding down its bond buying programs well ahead of the Federal Reserve, this has led to an increase in Canadian bond yields and our interest rates being higher than the US, which is supportive of the dollar. However, the BoC will still likely stay close to the Fed’s policies since they can’t risk hiking rates ahead of the US and our dollar moving much higher. Given this view I don’t see our interest rates moving materially higher than the US, so this should also help to limit further upside in the CAD.

Lastly, based on these factors (oil prices and interest rates), I developed a financial model that helps forecast ‘fair value’ of the Canadian dollar. Based on my expectations for oil prices and interest rates, my model suggests fair value at 81 cents, very close to its current level. Once again this suggest limited upside in the CAD from current levels.

Canadian Dollar Model Suggests Fair Value of 81 Cents

Source: Bloomberg, Turner Investments

Ok, time to bring it on home!

Based on my expectations for the factors discussed above, my financial model that suggests limited upside, and the range-bound trading pattern of the Canadian dollar, odds are we’re closer to a short-term top than a major breakout to the upside. Given this view we recommend investors/clients to stick with their US dollar investments and you may want to consider buying some US dollars for that vacation that you’re likely to go on next year as Covid begins to retreat.

Ryan Lewenza, CFA, CMT is a Partner and Portfolio Manager with Turner Investments, and a Senior Vice President, Private Client Group, of Raymond James Ltd.