July 2008

Why has the Canadian dollar failed to respond to record crude prices?

Since Jan. 1, 2008, an environment of broad commodity price strength has driven a 7.5 per cent appreciation in the Australian dollar versus the U.S. dollar, while Norway's "petro-currency," the krone, has risen by a similar 7.4 per cent versus the greenback. Over this same period, despite a roughly 30 per cent jump in light crude prices, the Canadian dollar has actually lost ground versus the U.S. dollar - down almost one per cent in the first four months of 2008 - and it is more than 10 per cent off its strong point from last November. 

Geography plays a part in explaining the loonie's lacklustre performance in recent months; Australian exports are primarily bound to Asian markets, and the majority of Norway's exports are sent to European nations. Both these regions are presently viewed as more robust than the United States, the end destination for the majority of Canada's exports. However, geography is far from being the sole factor in our domestic currency's lack of responsiveness to soaring energy prices. Two other material factors for the loonie's current malaise exist: a more currency neutral merger and acquisition pipeline thus far in 2008 and weakening interest rate differentials. 

M&A flow: Canadian dollar positive in 2007 but neutral in 2008 

Of all the cross-border deals closed during 2007, none was more significant than Rio Tinto's US$38.1 billion acquisition of Alcan. This deal captured the attention of the speculative community, both because of its sheer size and the fact that all shareholders were paid in U.S. dollars (raising the likelihood of material conversion flows). Net speculative bets against the Canadian dollar, as measured by non-commercial positioning on the Chicago Mercantile Exchange (CME), pushed net speculative bets in favour of the Canadian dollar to record highs. Given that Canadian dollar futures first started trading in 1972, this shift from record net short bets to record long bets in a nine-month window was quite astounding, and represented a massive US$15.7 billion swing in speculative sentiment in favour of the loonie.

Falling domestic yields reduce Canadian dollar's appeal to speculators 

Therefore, while Canada still retains its "petro-currency" status, speculators currently view Norway's krone as the better currency play for the expression of a bullish crude view. Not only is Norway's 5.50 per cent yield more attractive, but in addition Norway maintains a much larger current account surplus (an important metric when risk aversion rises) and has a more robust export base.

Recent CME data (for the reporting period ending May 6) confirm the importance of yield to speculators, with the two largest positive currency bets being the Australian dollar and Mexican peso (Australia has a 7.25 per cent benchmark rate, while Mexico has a 7.50 per cent benchmark rate). Both currencies are viewed as commodity plays, and the fact that positive bets on the Mexican peso sit near two-year highs illustrates that geography alone does not explain the lack of investor appetite for the Canadian dollar. With Mexico having even stronger trading ties to the United States, it is clear that investors are willing to look beyond geography if they are paid enough (in terms of yield).

While domestic inflation is showing signs of building, this will be more a story for 2009. In the interim, a Canadian dollar stronger than parity will be dependant on renewed foreign investor appetite for domestic resource assets - a condition that will surely draw speculators back to the loonie once again.  

June 20, 2008

By Shane Enright, currency strategist, CIBC World Markets 

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