The relentless appreciation of the Canadian dollar (CAD) has taken it to levels not seen post-World War II. The previous post-war high for the CAD versus the USD was USD1.0614 on August 20, 1957, according to James Powell's book A History of the Canadian Dollar.
This historical rate is referenced in part because, in extreme circumstances, such as those which currently exist in the CAD, foreign exchange market participants will tend to look for some historical perspective in terms of levels and conditions under which currencies traded in the past.
Although the CAD has exceeded that historic "extreme" in terms of levels, the conditions surrounding the currency's strength then and now are not entirely analogous, mostly because of capital controls in place back then. That besides the Bretton Woods framework (which did not specifically encompass the Canadian dollar at that time, but did limit the currency's movements given that the USD was fixed to most other currencies).
Nowadays, the free flow of goods and capital across borders results in a different and more dynamic method of establishing exchange rates.
Given those differences, not to mention the evolution of the Canadian and US economies over the past 50 years, comparisons of historical levels are not terribly helpful in terms of assessing current valuations and probable direction.
Moreover, those same differences as well as the lengthy time gap between now and then reduce the value of using those historical levels in current technical analysis. So, while it is an interesting exercise to look back and see what was happening the last time the CAD was this strong, more emphasis is put on current conditions and developments in terms of helping to assess the currency's likely path from here.
In that regard, the key pillars of CAD strength remain firmly in place, including high oil prices, continued solid performance of the Canadian economy, and a weak USD (not necessarily in that order).
The latest oil price gains are nothing short of dramatic as 'far flung' forecasts from recent years of US$100 per barrel are now on the cusp of being met and exceeded. In addition, natural gas prices (another big Canadian export) have moved to their highest levels since last autumn, in somewhat typical seasonal gains ahead of the winter. The upshot is that Canada's energy exports, in nominal terms, will improve further, providing a critical leg of support to the CAD while that persists.
In its most recent Monetary Policy Report (MPR), published in October, the Bank of Canada (BoC) estimated that the economy is operating even further above its production capacity than expected. And since that time, other developments suggest capacity constraints have increased.
Most importantly, the October labour market data showed the unemployment rate dropping to a new cycle low of 5.8 per cent, while employment figures surged, though most of the increase was mainly due to temporary employment in relation to the Ontario election.
Nonetheless, the economy continues to add jobs at an impressive pace, supporting the outlook for domestic demand but also reinforcing the assessment that the economy is operating above its production capacity.
In addition, the BoC also sees increased downside risks to growth. One risk stems from downgraded US growth expectations, although it is not clear to what extent slower US growth will be mitigated by continued strength in global demand for Canadian goods and services (mostly commodities).
Another downside risk stems from the currency as the combined effects of a stronger CAD and slower US consumption mean that net exports will be a drag on growth going forward. Of course, it remains to be seen how (or if) those risks are manifested, but for now they are deemed significant enough to argue against the kind of tightening in monetary policy that current economic conditions might otherwise justify.
Moreover, the BoC also estimated that the credit market crunch this summer effectively resulted in a 25-basis point tightening in the overnight rate. Of course, one can easily argue that the strength of the CAD itself is enough to keep the CAD sidelined, although the BoC cannot spell that out in such simple terms.
Nonetheless, not only has CAD strength already tightened monetary conditions, but raising rates further (or even threatening to do so) risks enhancing the current appreciation in the currency. And that is something the BoC would clearly like to avoid.
So far, BoC officials have stopped short of stronger verbal intervention against the CAD and, at this stage, they do not appear to be on the verge of taking specific policy action to curb strength in the currency.
That leaves the outlook for the CAD looking very much as it has been, i.e. bullish. There will inevitably be corrections - a USD rebound, a CAD pullback - but barring a more meaningful change in the underlying fundamentals, such developments should be viewed as temporary and within a broader trend of CAD strength. With calls of parity for USD-CAD now having been measurably exceeded, it is quite likely the currency pair will fall even further.
This report was compiled by Peter Calleya, manager, Corporate Strategy and Research, HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.