If you want to know how a country is progressing economically versus another country, look at the trend in the exchange rate. Currency traders for multinational companies are a “cut above” normal commodity traders. They are the “crème de la crème,” should we say? I think you get the picture. Cattle are priced on the world market in U.S. dollars; therefore, producers have significant currency risk, which is often overlooked. In this issue, I’m going to provide a brief overview of the main factors influencing the Canadian dollar.
During March 2020, the COVID-19 pandemic caused a world-wide recession. Equity markets dropped sharply as unemployment rates reached historical highs. Central banks dropped their benchmark interest rate to historical lows. The U.S. Federal Reserve dropped their short-term rate to 0.0 per cent to 0.25 per cent while the Bank of Canada followed suit setting their overnight rate to 0.25 per cent. In addition to lowering interest rates, the U.S. Federal Reserve and the Bank of Canada implemented quantitative easing and credit easing policies. Very simply, the central banks were buying government bonds in an effort to drive up the price, which lowers the yield. Banks base their lending rates on bond yields. The quantitative and credit easing programs are an effort to stimulate corporate borrowing and consumer spending.
This has two major implications for the Canadian dollar. Lower interest rates are bullish for the equity markets; there is a high correlation between U.S. equity markets and the Canadian-U.S. exchange rate. The resource-based Canadian dollar has been highly correlated with the Dow Jones Industrial average over the past eight months. Second, if the interest rate is higher in one country versus another country, investors will move their cash into the higher-yielding currency. Otherwise, there is an arbitrage opportunity.
Monetary policy from the U.S. Federal Reserve and the Bank of Canada was very similar from March through October. At the end of October, we saw a minor divergence. The Bank of Canada stated it would scale back bond purchases. The quantitative easing program would be tempered from $5 billion per week to a minimum of $4 billion per week. They are buying fewer bonds at lower maturities and more bonds with longer maturities. The central bank has also scaled back other easing program such as the Canada mortgage bond purchase program. While the Bank of Canada has scaled back, the U.S. Federal Reserve has kept their bond purchases at the same level. This is supportive for the Canadian dollar.
Another factor driving the Canadian-U.S. exchange rate is a fundamental shift in U.S. fiscal policy. This has caused all major currencies to appreciate against the U.S. greenback. President-elect Biden has promised a sweeping pandemic relief bill along with an overhaul of healthcare, immigration and education. Democrats are in the process of planning the most aggressive environmental protections in U.S. history, which will affect all industries and all sectors of the economy. The Democrats are also proposing corporate tax increases. The Democrats have a fierce progressive base with nearly 100 House Democrats belonging to this progressive caucus and their influence on Biden will be intense.
There are three factors specifically influencing the Canadian-U.S. exchange rate. Without going into detail, Canada has done a better job clawing back jobs in the third and fourth quarters of 2020. Recently, we’ve seen more COVID-19 pandemic constraints implemented in Ontario and Alberta but the overall view is that Canada’s job market will be in better shape once the COVID-19 vaccines are widespread across the country.
Second, inflation is slightly higher in the U.S. compared to Canada. The direct stimulus cheques in the U.S. will result in more money chasing fewer goods, and the U.S. inflation gap versus Canada will likely widen. A country with higher inflation has a weaker currency.
The third major point has to do with energy policy. There is a high probability that we’ll see U.S. crude oil production drop sharply over the next year. The U.S. was an exporter of oil under the Trump administration but they will once again turn to be a major importer under the Biden administration. There are ideas that West Texas Intermediate will be trading in the range of $60 to $70 next year. Higher energy prices are considered a tax increase and heavily influence the disposable income for about one-third of the U.S. population. Stronger crude prices will underpin the Canadian dollar as the U.S. is Canada’s largest customer.
In conclusion, we’ve seen a significant fundamental shift in U.S. fiscal policies. The implementation of left-wing policies is negative for the greenback. This has caused all major currencies to appreciate against the U.S. dollar. More specifically, there has been a minor divergence in Canadian and U.S. monetary policy as the Bank of Canada scales back their quantitative easing program. Inflation is expected to be higher in the U.S. compared to Canada over the next couple of years; higher crude oil values will be supportive for the Canadian dollar in the longer term.