The Canadian dollar against its US counterpart had one of the narrowest trading ranges of most major currency crosses in the last few months and had not closed below par since November of 2012. That all changed this week as we saw the loonie fall over a cent and a half and finished trading at close to 99 cents. There were a number of announcements and releases this week that triggered the downward trend in the Canadian dollar and it was led by both the IMF and Bank of Canada revising down their forecasts for economic growth and inflation, and further the Banks more dovish tone towards interest rates. Moreover, currency markets have once again become a little more interesting as the perception of “currency wars” is again explored by investors and the media.
Many of the economics departments of Canada’s financial institutions were pointing out that the loonie had been overvalued since last fall. With trade numbers, growth projections, and fundamental indicators all pointing to an overvalued currency, it was the stability in our government compared to the rest of the western world that was driving investors to park funds here in Canada. That being said, the recent realization that the United States is expected to experience more robust growth in 2013 and the stagnation of prices has seen our dollar return to under parity. As the Canadian dollar was exhibiting this status of a safe haven currency, it had even led the IMF to recommend its inclusion in a central banks basket of foreign exchange reserves. Despite the loonie falling off this week, the reality is the Canadian economy has not drastically changed course from where we were five months ago.
Jim Flaherty, speaking in Davos, Switzerland at the World Economic Forum summarized our growth path compared to the US quite well. To summarize, we are in a period of quite moderate economic growth, and in 2008 we experienced a little dip. The US, however, went a lot lower than us and is bound to accelerate and make their way back at a bit of faster pace. So it really raises the question of why financial markets continue to tell a different story then where the world sits from an economic standpoint.
US equity markets are at their highest levels in the last five years. They have come back from the lows of the Sub-prime crises of 2008 and ’09 and the confidence of investors is driving them higher and higher. The VIX, which tracks the implied volatility of the S&P, and for this reason is referred to as the fear index, is at its lowest levels on record.
So keeping the mindset of a student, questions arise surrounding why equity markets carry such optimism in this moderate growth environment. And this leads to the discussion and motivation of currency wars. Two central bodies can directly influence a country’s price level, and thus the exchange rate. One is the federal government through fiscal policy, and the other is a central bank via monetary policy. Either can do so, but this idea of devaluing a currency to give a competitive trade advantage so that a countries good are priced cheaper in foreign markets has been directly influenced by the actions of central bankers in initiating bond buying programs such as quantitative easing and keeping interest rates at record lows since 2006.
It’s hard to rationalize why in a period when government looks to be more and more anemic, and central bankers are relied on to engage in a competition of currency devaluation to stimulate economic activity, that the market place would be so optimistic. That being said, lets enjoy the ride of this rally and look for warning signs of it coming to an end.