What’s weighing on the loonie

The rise in oil prices hasn’t lifted the loonie, as typically expected. A big part of the reason lies stateside.

“The usual positive correlation between oil prices and the exchange rate has not been as strong of late, reflecting both uncertainty around Canadian pipeline capacity (and investment) and the expected increase in U.S. production (and investment),” says TD senior economist James Marple in a weekly economics report. He adds that NAFTA uncertainty weighs on the loonie.

Read: Story behind spiking oil prices, greenback appreciation: report

Similarly, in a monthly foreign exchange report, CIBC says that, instead of focusing on oil’s lift to the nominal trade balance, markets are focused on the trade hazards associated with drifting NAFTA talks, and a merely temporary exemption from U.S. tariffs on steel and aluminum.

“Although exports picked up late in Q1, a record monthly goods trade deficit reminded loonie-watchers that current trade-related [foreign exchange] flows are a burden on the Canadian currency,” says CIBC.

Read: Canada’s trade deficit hits record $4.1 billion while U.S. deficit falls

Moving beyond U.S. comparisons, however, reveals the loonie’s strong performance relative to other currencies—attributable to commodity prices in general, which could also ultimately improve Canada’s trade balance.

For example, taking the U.S. dollar out of the picture, “the Canadian dollar has left other currencies in the dust,” says BMO senior economist Sal Guatieri, in a weekly financial digest. “Excluding the big dollar, the trade-weighted loonie is up about 6% from two-year lows in mid-March.” The positive performance is thanks to oil prices, but also to the prices of other Canadian commodities, which have risen an average of 5% according to the Bank of Canada’s index.

In turn, “It’s only a matter of time before rising resource prices hack away at Canada’s record trade deficit,” says Guatieri. Trade balance improvement will likely come at the expense of the U.S., he says, given disparate currency moves.

Read: Higher prices mean it’s time for ‘torquier’ oil names

For example, the loonie’s trade-weighted value, excluding the U.S. dollar, is above its long-run mean, which suggests some overvaluation, “a view reinforced by the worsening trade shortfall with China, Mexico and Germany,” says Guatieri.

In contrast, the loonie’s value against the U.S. dollar (about US$0.78) is roughly in line with StatsCan’s estimate of the exchange rate that equalizes the average price of goods in the two countries, suggesting the loonie will have a mostly neutral impact on trade between the two countries.

Regardless, “Canada’s largely balanced trade position with the U.S. should improve this year on the back of higher resource prices and stronger U.S. demand, courtesy of a ballooning U.S. budget deficit,” says Guatieri.

On the downside, this expected improvement in Canada’s trade balance with the U.S. likely won’t help seal a NAFTA deal, so Canada should act quickly in those negotiations.

Says Guatieri: “China doesn’t have a balanced-trade leg to stand on in current negotiations with the U.S., but Canada does—for now. It would be wise to make hay while the sun still shines.”

Loonie outlook

Also affecting the loonie are aggressive expectations for rate hikes this year. “That leaves room for a weaker Canadian dollar if, as we expect, Governor Poloz moves more cautiously,” says CIBC.

The bank expects the U.S. dollar to lose ground against other major currencies, so isn’t calling for loonie depreciation beyond $1.32 this year (the bank’s currency outlook for Q3). For example, the euro should rise against the U.S. dollar as the European Central Bank potentially starts to unwind quantitative easing. And, as CIBC chief economist Avery Shenfeld explains in a weekly economics report, the loonie is highly correlated with the euro.

Though a firmer euro will keep the loonie from depreciating much against the U.S. dollar, that lack of depreciation also has negative economic consequences.

Says Shenfeld: The country seems to need a weaker loonie “to overcome its lack of success in attracting companies to expand on this side of the border in the face of [U.S.] trade, tax and regulatory policies.”

Read: Investing during tough times for trade

Read the full reports from TD, CIBC (foreign exchange), BMO and CIBC (weekly).

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Big banks weigh in on inflation, bonds, rate hikes