Watching the Fundamentals of Canadian Dollar Price Movement

04/09/2010 12:01 am EST

Focus: FOREX

This month, the Canadian dollar broke parity with the US dollar, an exciting development. Will these gains continue for the Canadian dollar? I think so, but commodities are key to the equation, as are interest rates.

Looking back, September 20, 2007, was the first time in nearly three decades that the Canadian dollar reached parity with the US dollar. Fueled by strong commodity prices, the Canadian dollar soared to a high of $1.1043 before falling back into a range of $0.97-$1.03. It traded within that range until the global financial crisis began in August 2008. With gigantic firms such as Lehman Brothers and Bear Sterns failing, investors became risk-averse and bought US Treasuries. That helped spark a short and powerful move up in the US dollar, which weakened the Canadian dollar. The Canadian banking system managed to survive the crisis better than most nations' banking systems, and as we saw commodity prices recover, so too did the Canadian dollar, from a bottom of 0.7653 in March 2009.

In the last few months, traders and analysts have been anticipating that the Canadian dollar would hit parity. Now that parity has been reached, some are taking their positions off, but many are letting their bets ride with the belief that the Canadian dollar still has a lot of upside potential.


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It is very important to understand the product that you are trading. When an investor buys (goes long) a Canadian dollar futures contract, what they are really doing is selling US dollars and buying Canadian dollars. It is often referred to as a pairs trade. If you believe the Canadian dollar will outperform the US dollar, you would buy Canadian dollar futures. You would sell if you believe the opposite. When I refer to Canadian dollar prices throughout this article, I am referring to futures prices, which are quoted inversely to cash prices.

A Bloomberg poll of 34 different analysts shows a consensus forecast for the Canadian dollar futures to be at approximately 0.96 by the end of the second quarter, and to appreciate to 0.97 by the end of the third quarter of this year. Thus, the majority of analysts are not expecting the Canadian dollar to stay above parity for long; they expect a pullback.

More recently, Canadian dollar futures were trading in a range of 0.93 - 0.98. Traders were successful buying at the low end of the range and selling at the high end of the range for many months, while long-term investors in the Canadian dollar waited for personal targets, many being the expectation of parity. It must be noted that parity is not a strong technical resistance level, but more of a psychological level. Near $1.02 – $1.0250 is where I believe the Canadian dollar will reach strong resistance. Volume is a very important factor when looking for breakouts and key resistance levels. However, the Canadian dollar, like much of the market, has been moving swiftly higher without resistance and on relatively low volume, with no end in sight.


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NEXT: Key Factors Impacting the Canadian Dollar

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Factors Impacting the CAD

GDP: Canada and US

Gross domestic product is a good benchmark for evaluating a nation’s economy. In the graph below, the red line represents the US GDP, while the white line represents the Canadian GDP. From the slope of the lines, it is clear that the Canadian economy has been improving more rapidly than that in the US, a good sign for the Canadian dollar.


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Employment

Looking at employment figures, Canada has about a point and a half less unemployment, which shows that Canada has not been hit nearly as hard as the US by the economic downturn. Hopefully we’ll see it hover around the six or seven percent level, which is close to Canada's natural rate of unemployment. More important than the unemployment rate is job creation.  Looking at the next chart, it's easy to see that Canada has withstood this downturn much better than the US, with minimal job losses. Noting that the US has a population ten times greater than Canada's, a simple adjustment to make the figures equal is to multiply the Canadian number by ten. As such, in February, the number of jobs created in Canada, in equivalent terms to the US, was 200,900 (20,900 x 10).

Job Creation: Canada and US


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Interest Rates

One of the reasons the unemployment rate is falling is because interest rates have dropped dramatically. Canada’s benchmark short-term lending rate is at a quarter of one percent, close to the US range at zero to a quarter of one percent. Central banks need to lower rates to stimulate the economy; to get people spending and banks lending. Analysts feel the Bank of Canada is likely to raise rates sooner than in the US. A rate increase is anticipated in Canada at the end of the second quarter of 2010, whereas no rate increases are expected until the fourth quarter of 2010 in the US.

Inflation

Inflation is an important factor in terms of central bank actions. Canada's current inflation rate of 1.6% is in the middle of the Bank of Canada’s target rate between one and three percent. Bank of Canada officials have communicated expectations for rates to stay at 0.25% until July 2010, conditional on inflation. Since Canada's inflation numbers have been rising more quickly than previously expected, there are some concerns that the Bank of Canada may hike interest rates sooner in order to contain inflation.

When the Canadian dollar strengthens, it tends to push inflation down as the prices of imported goods become cheaper. Further, a weak US dollar makes imports into the US more expensive and creates inflation—one reason why inflation is greater in the US than in Canada. Canada is a resource-rich country, and its dollar is heavily driven by commodities. So when evaluating the Canadian dollar, the outlook for commodities must be taken into consideration. A surge in crude oil has helped buoy the Canadian dollar, hitting an 18-month high above $87 a barrel in early April. However, I think crude oil is a bit top-heavy and may pull back in the near term. But overall, I expect overall commodity prices to continue to rise, which is bullish for the Canadian dollar.

NEXT: Upcoming Central Bank Meetings in US and Canada

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Inflation: Canada and US


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Anyone thinking about trading the Canadian dollar needs to be aware of an important date ahead: April 20, 2010. That’s when we have the next Bank of Canada policy meeting, and it could set the market up for a rate increase. If that occurs, we may see a jump in the Canadian dollar. With much of the market already anticipating good news, some make the argument that any hawkish news coming from the report will already be priced into the Canadian dollar. Before the announcement on April 20 might be a good time to take some money off the table, just in case there is no change in the wording of the report.

In the US, the Federal Reserve’s next policy meeting on April 28. US policymakers have been quite dovish, continually stating they will keep "exceptionally low levels" of the federal funds rate for an “extended period." If we get some hawkish wording at the April policy meeting, even if they just take out "exceptionally" and state "low levels," it should cause the US dollar to rally. When there is an indication of a rate increase ahead in the US, it should push commodities down and impact the Canada dollar.

Given the prospect for higher interest rates and higher commodity prices, I believe the Canadian dollar is in a long-term bull market. The upward path will not be straight up, and investors should expect higher levels of volatility moving into a period of potential interest rate increases.

If you are bullish the Canadian dollar, selling puts can be a good strategy to get into the market at a lower price on a pullback. You might consider selling a put at a strike of 0.97 or 0.98, and as an options seller, you receive the premium. If the market never comes down to that level and that put expires worthless, you keep the premium you collected, and walk away with a small profit. If the dollar drops and the put expires in the money, you are then assigned a long position in the Canadian dollar at your strike price, and still get to keep your premium. Of course, you bear the risks of holding that futures position if you choose to do so, which are potentially unlimited.

By Drew Shaw of Lind-Waldock

Drew Shaw is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at dshaw@lind-waldock.com.

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