Beginner’s Guide to Trading the Loonie

06/30/2011 7:00 am EST

Focus: FOREX

The Canadian dollar, or “loonie,” has strengthened and now plays an increasingly more important role in world currency markets. Here are the factors that drive the loonie and how forex traders can play it.

Just seven currencies account for over 80% of the total volume of the forex market, and the Canadian dollar (often called the "loonie" because of the appearance of a loon on the back of the Canadian one-dollar coin) is one of these major currencies and is the sixth-most held currency as a reserve.

This is somewhat of an anomaly, as Canada's economy (in terms of US dollars of GDP) is actually number ten in the world. Canada is also relatively low on the list of major economies in terms of population, but it does stand at ninth in the world in terms of its dollar-value exports.

Anomalies are somewhat par for the course with the loonie, though. The Canadian dollar was not part of the original Bretton Woods system, and so it floated freely until 1962 when extensive depreciation toppled a government, and Canada went with a fixed rate until 1970 when high inflation prompted the government to move back to a floating system.

All of the major currencies in the forex market have central banks behind them. In the case of the Canadian dollar, it is the Bank of Canada. Like all central banks, the Bank of Canada tries to find a balance between policies that will promote employment and economic growth while containing inflation.

Despite the significance of foreign trade to Canada's economy (and the influence that currency can have on that), the Bank of Canada does not intervene in the currency. The last intervention was in 1998, when the government decided that intervention was ineffective and pointless.

The Economy Behind the Canadian Dollar

In terms of GDP (measured in US dollars), Canada is the word’s tenth-largest economy. Canada has enjoyed relatively strong growth over the last 20 years, with two relatively brief periods of recession in the early 1990’s and 2009. Canada had persistently high inflation rates, but better fiscal policy and an improved current account balance have led to lower budget deficits and lower inflation rates.

In analyzing the economic situation in Canada, it is also important to consider Canada's exposure to commodities. Canada is a meaningful producer of petroleum, minerals, wood products, and grains, and the trade flows from those exports (nearly 60% of the country's total exports) can influence investor sentiment regarding the loonie.

As is the case for virtually all developed economies, this data can be readily found on the Internet through sources like the Agriculture and Agri-Food Canada Web site.

Although the average age of Canada's population is high relative to global standards, Canada is relatively younger than most other developed economies. Canada has a relatively liberal immigration policy, though, and Canada's demographics are not especially troubling for the long-term economic outlook.

Because of the tight trading relationship between Canada and the United States (they both make up over half of the other's import/export market), traders of the Canadian dollar have to keep an eye on events in the United States as well. While Canada has pursued very different economic policies, the reality is that conditions in the US inevitably spill over into Canada to some extent. (It also influences other economic phenomena, such as inflation.)

What is particularly interesting about that relationship is how conditions can diverge. The structure of Canada's financial market helped the country avoid many of the problems with bad mortgages that affected the US. On the other hand, the lesser significance of technology companies to Canada's economy led to relative weakness in the Canadian dollar during the tech boom in the US in the 1990’s. The commodity boom of the 2000’s (particularly in oil) led to outperformance for the loonie, however.

NEXT: Key Drivers of Canadian Dollar Pricing

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Drivers of the Canadian Dollar

Economic models designed to calculate the "right" foreign currency exchange rates are notoriously inaccurate when compared to real market rates, due in part to the fact that economic models are typically based on a very small number of economic variables (sometimes just a single variable like interest rates).

Traders, however, incorporate a much larger range of economic data into their trading decisions and their speculative outlooks can themselves move rates just as investor optimism or pessimism can move a stock above or below the value its fundamentals suggest.

Major economic data includes the release of GDP, retail sales, industrial production, inflation, and trade balances. These come out at regular intervals, and many brokers, as well as many financial information sources like The Wall Street Journal and Bloomberg, make this information freely available.

Investors should also take note of information on employment, interest rates (including scheduled meetings of the central bank), and the daily news flow. Natural disasters, elections, and new government policies can all have significant impacts on exchange rates.

As is often the case with countries that rely on commodities for a sizable portion of their exports, performance of the Canadian dollar is often related to the movement of commodity prices. In the case of Canada, the price of oil seems to be especially significant in currency moves, and it generally seems to pay off to go long loonies and short oil importers (like Japan, for instance) when oil prices are moving up.

Along similar lines, there is some impact on the loonie from fiscal and trade policy in countries like China; countries that are major importers of Canadian materials.

Capital inflows can also drive action in the loonie. During periods of higher commodity prices, there is often increased interest in investing in Canadian assets, and that influx of capital can impact exchange rates. That said, the carry trade is usually not so significant for the Canadian dollar.

Unique Factors for the Canadian Dollar

Given the relative economic health of Canada, the country has a relatively high interest rate among developed economies. Canada also enjoys a relatively newly-won reputation for balanced fiscal management and finding a workable middle path between a state-dominated economy and a more hands-off approach.

That can become more relevant during periods of global economic uncertainty, and though not a reserve currency like the US dollar, the Canadian dollar is seen as something of a global safe haven.

In point of fact, though, while the Canadian dollar is not a reserve currency like the US dollar, that is changing. Canada is now the sixth most commonly held reserve currency, and those holdings are increasing.

The Canadian dollar is also uniquely tied to the health of the US economy. Though it would be a mistake for traders to assume a one-to-one relationship, the US is a huge trade partner for Canada, and US policies can have significant influence over the course of trading in the Canadian dollar.

The Bottom Line

Currency rates are notoriously difficult to predict, and most models seldom work for more than brief periods of time. While economics-based models are seldom useful to short-term traders, economic conditions do shape long-term trends.

Though Canada is not an especially large country and is not among the very largest exporters of manufactured goods, the country's economic vitals are stable and the country has found a good balance between profiting from its natural resource wealth and risking "Dutch disease" from over-reliance on these goods.

As Canada becomes an increasingly viable alternative to the US dollar, traders should not be surprised to see the loonie become more important in the forex market.

By Stephen D. Simpson, contributor, Investopedia.com

Stephen D. Simpson, CFA, is a freelance financial writer, investor, and consultant. He has worked as an equity analyst for both buy- and sell-side investment companies in equities and fixed income. Stephen's consulting work has focused primarily upon the health care sector, while he has also written extensively on topics pertaining to investments, security analysis, and health care. Simpson operates the Kratisto Investing blog and can be reached there.

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