The Canadian dollar has been quite volatile over the past year and look for this erratic action to continue. While the loonie sustained a decent rally from 77 to 94 cents U.S., the market has struggled to maintain the upward trend and appears to be moving into a consolidation pattern. This is not uncommon for a market to consolidate for a couple months before resuming a longer-term trend. The competitive advantage of the weaker exchange appears to be eroding. Dips in the market are viewed as opportunities to take some protection on the exchange rate.

A major factor influencing Canadian dollar demand is exports. While our economy has been contracting, exports are expected to increase next year which should bring on demand for Canadian dollars. The Canadian trade balance should move back into a normal surplus position as the world comes out of recession and demand for resources improves.

Many analysts are focusing on the U.S. inflation and negative fiscal policy to weaken the greenback against other major currencies. Inflation will likely be the only way for the U.S. to pay down its large deficit. In addition to the adverse fiscal policy, U.S. monetary policy has also weighed on its dollar. The U.S. treasury has been printing money to buy longer-term bonds. Long-term mortgage rates are based on 10-, 20-and 30-year bond yields. Therefore this quantitative easing program drives up bond prices and lowers the yields. Banks have offered lower interest rates and many homeowners have been able to refinance. Some analysts feel we are at the height of the quantitative easing program. Bond prices will start to decline and yields will increase next year.

At this time, U.S. short-term interest rates are expected to strengthen later in 2009 and continue slowly trending higher in 2010. Rising U.S. interest rates longer term should reinforce U.S. dollar confidence. Canadian interest rates are expected to move in line with the U.S. However, if U.S. interest rates start to show a premium over Canadian rates, this may temper the strength in the Canadian dollar.

At this time, the Bank of Canada has shied away from a quantitative easing program which is a positive signal. To offset the strength in the loonie, the Bank of Canada intervenes when the loonie nears 94 U.S. cents. Canada has a so-called “fixed floating” exchange rate whereby the Central Bank intervenes if they feel the exchange rate is hindering economic growth. This usually only works for a short period as even the Central Bank has limits and it is impossible to change the tide flow.

Over the past year, the greenback has been viewed as a safe haven during the stock market decline. Large institutional traders had a tendency to sell equity market rallies and buy the U.S. dollar. We are now starting to see institutional-type traders unwind these “short equities/long U.S. dollar” spreads. These traders are also buying the Canadian dollars and other major currencies while selling U.S. dollars. Crude oil prices are a major factor influencing equity prices and the value of the Canadian dollar. The fundamentals appear to be tightening for the crude oil when looking forward six to 12 months. Therefore, we may see dips in the crude oil prices but longer term; the market is expected to trend higher.

Canadian fiscal policy is also negative for the Canadian dollar. Lower government incomes and the potential for an election could erode confidence in the Canadian economy. However, this usually only causes temporary volatility and then the market resumes normal course of action based on current fundamentals and trade flows.

In conclusion, U.S. fiscal and monetary policy should result in a weaker U.S. dollar longer term. The Canadian dollar strength will be dependent on the U.S. coming out of recession next year, increasing exports, and expanding U.S. and global economies. Canadian monetary policy has been viewed as positive for the Canadian dollar relative to the greenback because Canada has not implemented a quantitative easing program. However, the Bank of Canada can intervene if it feels the exchange rate is hurting economic growth. The Canadian dollar has started a longer-term upward trend which is expected to continue.

Gerald Klassen analyzes markets in Winnipeg and also maintains an interest in the family feedlot in southern Alberta. For further information, comments or questions, he can be reached at[email protected]or 204 287 8268.

The material contained herein is for information purposes only and is not to be construed as an offer for the sale or purchase of securities, options and/or futures or futures options contracts. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. The risk of loss in futures trading can be substantial. The article is an opinion only and may not be accurate about market direction in the future.