Canadian dollar highs set to continue

A series of factors have contributed to the Canadian dollar's well documented move to 28-year highs and, looking ahead, the bullish backdrop for the currency looks to remain in place for the foreseeable future. The overall fundamental conditions supporting the Canadian dollar are:

1) continued expansion in the economy;

2) tighter monetary policy and rising market interest rates;

3) fiscal and external surpluses, especially critical at a time when markets have focused on global imbalances; and

4) high energy prices.

A key event for the Canadian dollar recently has been the Bank of Canada's Monetary Policy Report. In it, the Bank of Canada (BoC) stated that a further "modest increase in the policy interest rate may be required", reducing speculation that the recent interest tightening (which put the overnight rate at 4%) would be the final interest rate hike in the cycle.

Moreover, the BoC stated that "fundamental factors" such as rising commodity prices have supported the Canadian dollar since the previous Monetary Policy Report. In assessing currency movements as being driven by "fundamental factors", it implies that Canadian dollar movements played less of a role in the BoC's policy decision.

In fact, the strength of the Canadian dollar did not stop the BoC from raising interest rates in April and again in May. If the BoC had described currency gains as driven by increased foreign demand for Canadian financial assets, then the impact on policy presumably would have been more significant, potentially stopping them from raising interest rates.

Not only did the BoC raise interest rates, but it indicated little concern, in terms of a policy influence, over the Canadian dollar's appreciation. That was a key catalyst for the latest decline in the US dollar-Canadian dollar exchange rate. However, markets should not take that to assume that the BoC will assess future exchange rate movements in the same manner.

The BoC aborted its tightening programme in the autumn of 2004, due in part to accelerated Canadian dollar gains at the time. Although the BoC recently raised interest rates by 25 basis points, further Canadian dollar gains could tip the scales against such a move. Such speculation in the market, for and against future BoC tightening, will have a bearing on the Canadian currency in the coming months.

However, the Canadian dollar has other factors working for it as well. The April G7 statement heightened the market's attention on global imbalances, and on measures that would help to resolve them. Quite obviously, the market's key focus in the wake of that statement was the importance of introducing flexibility into currency regimes in emerging market economies where it is currently lacking.

That, in turn, has intensified downward pressure on the US dollar, which has fallen not only against Asian currencies (which were largely the point of the communiqué) but also against the major and more liquid currencies. The US dollar's broad-based weakness on the back of these events has contributed to the decline in the US dollar-Canadian dollar exchange rate.

In addition, Canada is in the 'winners' category in the global imbalances assessment, while also maintaining exchange rate flexibility that many other countries with current account surpluses lack. That has also increased the outright appeal of the Canadian dollar, rather than the currency simply rising as the default result of a weaker US dollar.

If markets continue to focus on global imbalances in the coming months as expected, Canada's current account and fiscal surpluses will clearly help to support the Canadian dollar over that time.

In the broader picture, there has been unevenness in some recent Canadian economic data. The problems of the manufacturing sector have been well documented and will not be resolved quickly or easily.

On the other hand, employment remains robust. At 6.4%, the unemployment rate remains near a 30-year low, reflecting the type of capacity constraint that supports a tightening bias at the BoC. Importantly, wages are rising as well, suggesting healthy consumption going forward as well as an inflation risk.

Fiscal developments also bode well for growth. In the near term, the new Conservative government's budget calls for a 1% cut in the General Sales Tax to 6%. In the medium term there is also a proposal to reduce the corporate tax rate to 19% by 2010 from the current 21%, and for the capital gains tax to be eliminated as of January 2007. At this stage, this is not being viewed by the market as threatening Canada's fiscal position.

The one other positive factor for the Canadian dollar is commodity prices. Oil rose to new all-time highs in the past month, generating several sources of support for the Canadian dollar. In outright terms, it increases windfall US dollar receipts to Canadian energy companies, which are converted into Canadian dollars.

This in turn supports longer term FDI into Canada's energy sector. Furthermore, while there was little cross border M&A flow into Canada this past month, domestic M&A activity in the energy sector is ongoing. That will support additional speculation in Canadian equities by both domestic and foreign investors, representing another potential boost to the Canadian dollar.