Dollar not out of the woods yet

The Canadian dollar has suffered through a rough ride so far this month, but don’t expect it to recover anytime soon. Bank economists say the dollar has more downside potential, but whether the downturn is cyclical or just momentum remains up for debate.

“The movement we have seen in the Canadian dollar in the month of October is not just the largest monthly move ever; it’s by a very large margin the largest monthly move,” says Matthew Strauss, vice-president, senior currency strategist, RBC Capital Markets. “So far this month we’ve moved more than 20 cents, whereas the previous largest monthly move was only nine cents. We are in extraordinary times at the moment.”

He says the massive sell-off in the Canadian dollar initially looked like panic selling, with the loonie simply following other currencies. But it soon became clear that the Canadian sell-off was driven more by falling commodity demand.

“In October, commodities took over from broad-based U.S. dollar strength as the primary driver of the Canadian dollar. Consequently, we saw the Canadian dollar weakening against all other major currencies.”

“More problematic was [crude’s] move towards $70 or $75 and below, because that’s generally seen as the break-even point for new oilsands extraction and mining projects,” says Strauss. “From that perspective, the big support for the Canadian dollar since 2003 has now turned around very significantly in this last month.”

He points out that the International Monetary Fund recently cut its outlook for global growth to just 3%, which is viewed as the threshold for a global recession. With global growth grinding to a halt, demand for virtually all of Canada’s export commodities will dry up.

Strauss is hopeful that the U.S. economy could show signs of recovery in the second half of 2009 but warns that this recovery will be a long, slow process, rather than a bounce. This too would be the signal for some slow recovery in the Canadian dollar, but the value of the loonie will be “significantly weaker” than it is currently.

“It is possible for the Canadian dollar to depreciate by, I would say, at least another 5% in the months ahead. How far it will fall will depend very much on the global recession.”

In the event of a deep, prolonged slowdown, he says, RBC’s worst-case scenario envisions the dollar falling to below 70 cents U.S.

Pascal Gauthier, economist at TD Economics, thinks the flight to the U.S. dollar is largely a traditional flight to safety, despite the fact that America is the source of the world’s current economic plight.

“You always get this paradox when the U.S. economy is doing poorly, that the U.S. dollar, in fact, can do very well,” he says. “There’s enough near-term momentum to bring it down a little further. I think a lot of it is just liquidity being required in U.S. dollar–denominated assets, be it bonds or just pure cash.

“I think the strength of the U.S. dollar is more of a near-term effect, and that is certainly warranted.”

He points out that it’s not just the loonie that’s sinking and that the American dollar is one of three currencies that are seeing increased interest; the Japanese yen and the Swiss franc are also both on the rise.

Gauthier also points to the “massive reversal” of the carry trade, with investors borrowing in low-interest-rate currencies like the yen, and investing in higher-rate environments. As interest rates fall in countries like Australia and New Zealand, the spread between their rates and the Japanese rate narrows, making the carry trade less appealing.

“When you look at the number of hedge funds that are either closing shop or covering some margins — a lot of them are heavily invested in commodities, so a good part of that unwinding appears to have occurred already, but it does suggest that there’s still a little further [decline] to come.”

Since the Canadian dollar is largely seen as a commodity currency, falling prices have compounded the sell-off of the loonie.

“[Commodities] have retreated more than significantly … they’ve retreated massively since peaking in July,” Gauthier says. “As it’s digested that the world economy is probably going to head into a mild recession, the dollar will find a bottom and then pick up a bit as growth improves, in late 2009 or 2010.”

He says that the massive investment in the U.S. dollar could be taken as a show of support; a signal that the world still has confidence in the U.S. economy.

“It would be difficult for me to express a sentiment different from what the market is expressing with cold hard cash. They’re basically taking a 0% interest rate on short-term bonds just to be able to get that principal back.”

Investors searching for a safe haven have few options these days, with Europe and Asia looking just as weak as America. With Europe’s traditionally weaker fiscal position and Asia’s volatility, investing in the U.S. seems like the safer bet. Meanwhile, the Canadian dollar gets walloped as a bystander.

“Further down the road, this looks a little low for the Canadian dollar, so we expect it to inch back up, but probably not all the way back up to parity in the forecast horizon, say, 12 to 18 months or so,” he says.

Is there an upside to the weaker loonie? The strong dollar was blamed not only for crippling Canada’s export manufacturers but also for wiping out gains made in foreign investments over the past four to five years.

“Foreign investments will obviously benefit from the weaker dollar, but given our outlook of continued weakness and uncertainty about the global economy, the volatility will continue,” says Strauss. “The risk factor has to be taken into account.

“Any forecast could turn out to be not only wrong, but significantly wrong in a very short time period.”

And things don’t look much better for manufacturers either.

“Certainly for exporters this is not a negative, but the main headwind they’re facing right now is lower demand,” says Gauthier. “In the current environment, the weaker Canadian dollar is more helping to dampen the losses than to put them in the black. U.S. consumers are not likely to purchase more cars just because Canada gains a 10% to 15% advantage on the currency.”

Filed by Steven Lamb, Advisor.ca, steven.lamb@advisor.rogers.com

(10/28/08)