During March 2020, the Canadian dollar dipped to a four-year low, near 68 U.S. cents, at the onset of the COVID recession. Central banks across the world responded with an aggressive monetary policy to stimulate the economy. The U.S. Federal Reserve and the Bank of Canada dropped their interest rate to historical lows.
The two central banks started buying treasuries and mortgage-backed securities. Buying bonds drives up prices and lowers yields. Banks and financial institutions base their loan rates on yields of government bonds. The U.S. Federal Reserve also lowered the reserve requirements for major banks to encourage banks to lend more money. To clarify a common misconception, the buying of bonds or treasuries by the central bank is often referred to as quantitative easing or “printing money.” Printing money is NOT running a printer to physically print more dollar bills.
The resource-based currency quickly recovered. Stimulus measures from central banks worked remarkably well. Equity markets and the Canadian dollar made their lows in March 2020. However, by mid-November, the Dow Jones Industrial Average hit fresh historical highs. News of vaccine developments enhanced the economic recovery last fall and by April 2021, there was an aggressive vaccine rollout in both Canada and the U.S. Rounds of government stimulus and social supports contributed to economic growth. In the U.S., analysts estimate that consumers saved close to $2 trillion over the year.
We all remember that crude oil dipped into negative territory during April 2020 due to the global economic slowdown. This was short-lived. Stimulus measures from major central banks and supportive fiscal policy from governments enhanced demand for all commodities. Crude oil futures topped $76/barrel in July, a three-year high. Lumber, copper and all major resources traded at fresh historical highs. The housing and construction sector is a leading indicator of the economy as are equity valuations.
Consumer spending is two-thirds of U.S. GDP. The low interest rate environment spurred housing demand. Consumers were in good shape through the recession. Keep in mind this is the only recession in history where average incomes in Canada and the U.S. increased due to government support. Consumer disposable income surged during 2020 and the first half of 2021.
The U.S. Federal Reserve cut its lending rate to 0.0-0.25 per cent at the start of the recession. At the same time, the Bank of Canada lowered its benchmark rate to 0.25 per cent. The Bank of Canada’s quantitative easing program, which started in April 2020, included buying $5 billion worth of bonds per week. The central bank started tapering its bond purchases by cutting purchases to $4 billion per week during October 2020. The next tapering occurred in April to $3 billion. This was followed by further tapering to $2 billion per week in July.
The U.S. Federal Reserve quantitative easing program included buying treasuries and mortgage-backed securities of $120 billion per month. Federal Reserve chairman Powell stated in August that inflation and employment levels are at comfortable levels. Bond purchase tapering will start soon but he did not give a specific time frame.
Until the summer of 2021, the Bank of Canada’s monetary policy was considered more hawkish than the U.S. Federal Reserve. This divergence in monetary policy, along with rising demand for resources and increasing exports, resulted in a stronger Canadian dollar. These factors are starting to neutralize. Export demand has slowed, commodity prices have come off their highs, the U.S. Federal Reserve and Bank of Canada’s policies are now viewed as very similar. Bond yields are increasing.
The economy will move from an aggressive expansionary phase to the peak phase. (The four stages of an economic cycle are peak, contraction, trough and expansion). Higher interest rates and the bullish U.S. dollar will weigh on the Canadian dollar. U.S. second-quarter GDP came in at 6.6 per cent; however, second-quarter GDP will likely finish in the range of 3.8 per cent to 5.0 per cent. Equity or stock market values will likely peak by the end of 2021 or first quarter of 2022. Interest rate hikes are expected from the Bank of Canada and the U.S. Federal Reserve by the end of 2022.
I don’t feel the Canadian dollar will fall apart but the June highs have likely defined the upside potential. We would need to see further upside in crude oil values and a more hawkish tone from the Bank of Canada compared to the U.S. Federal Reserve to move the market higher. Higher commodity values help the Canadian balance of trade, which has been fluctuating between positive and negative over the past year.
A low-interest-rate environment is bullish for equity markets and bearish for the U.S. dollar. A weak U.S. dollar is bullish for commodities and the Canadian dollar. We could swap in “Canadian dollar” for “commodities” in the diagram above.
The U.S. Federal Reserve will start tapering bond purchases while the Bank of Canada will continue to curb purchases over the next six months. In 12 to 16 months, central banks will start increasing benchmark lending rates. We will see rising interest rates moving forward.