Chapter 33
Currency Profile: Canadian Dollar (CAD)

Broad Economic Performance

Canada is the world's eleventh largest country with GDP valued at US$1.8 trillion as of 2014. As a resource-based economy, the country's early economic development hinged on the development, exploitation, and exports of natural resources. It is now the world's fifth largest producer of oil and gold. However, in actuality, nearly two-thirds of the country's GDP comes from the service sector, which also employs three out of four Canadians. The strength in the service sector is partly attributed to the trend by businesses to subcontract a large portion of their services. This may include a manufacturing company subcontracting delivery services to a transportation company. Despite this, manufacturing and resources are still very important for the Canadian economy, as it represents over 25% of the country's exports and is a primary source of income for a number of provinces.

The Canadian economy started to advance with the depreciation of its currency against the U.S. dollar and the Free Trade Agreement that came into effect in January 1989. This agreement eliminated almost all trade tariffs between the United States and Canada. As a result, Canada now exports over 85% of its goods to the United States. Further negotiations to incorporate Mexico created the North American Free Trade Agreement (NAFTA), which took effect on January 1994. This more advanced treaty eliminated most tariffs on trading between all three countries. Canada's close trade relationship with the United States makes it particularly sensitive to the health of the U.S. economy. If the U.S. economy sputters, demand for Canadian exports would suffer. The same is true for the opposite scenario; if U.S. economic growth is robust, Canadian exports will benefit. In the past decade, trade with China has also increased significantly, rising in the ranks from the fifth to the second most important trade partner for Canada. The following is a breakdown of Canada's key export and import markets:

Leading Export Markets

1. United States
2. China
3. United Kingdom
4. Japan
5. Mexico

Leading Import Sources

1. United States
2. China
3. Japan
4. Mexico
5. United Kingdom

Monetary and Fiscal Policy

The Governing Council of the Bank of Canada is the board that is responsible for setting Canadian monetary policy. This council consists of seven members: the governor and six deputy governors. The Bank of Canada meets approximately eight times per year to discuss changes in monetary policy. They also release a monthly monetary policy update every quarter, but the rate decision itself is the big market mover for the currency.

Central Bank Goals

The Bank of Canada's primary focus is on maintaining the “integrity and value of the currency,” and this involves ensuring price stability. Price stability is maintained by adhering to an inflation target currently set by the Department of Finance at 1% to 3%. The Bank believes that high inflation can damage the functioning of the economy. In their opinion, low inflation on the other hand equates to price stability, which can help to foster sustainable long-term economic growth. The BoC controls inflation through short-term interest rates. If inflation is above the target, the Bank will apply tighter monetary conditions. If it is below the target, the Bank will loosen monetary policy. Overall, the central bank has done a pretty good job of keeping the inflation target within the band since 1998.

The Bank measures monetary conditions using its Monetary Conditions Index, which is a weighted sum of changes in the 90-day commercial paper rate and G-10 trade-weighted exchange rates. The weight of the interest rate versus the exchange rate is 3 to 1, which is the affect of a change in interest rates on the exchange rate based on historical studies. This means that a 1% increase in short-term interest rates is the same as a 3% appreciation of the trade-weighted exchange rate. To change monetary policy, the BoC manipulates the Bank Rate, which can in turn affect the exchange rate. If the currency appreciates to undesirable levels, the BoC can decrease interest rates to offset the rise. If it depreciates, the BoC can raise rates. However, interest rate changes are not used for the purposes of manipulating the exchange rate. Instead, they are used to control inflation but an excessively strong currency and lower inflationary pressures can accelerate the changes. The following are the most commonly used tools by the BoC to implement monetary policy.

Bank Rate

The Bank Rate is the main rate used to control inflation. This is the rate of interest that the Bank of Canada charges to commercial banks. Changes to this rate will affect other interest rates, including mortgage rates and prime rates charged by commercial banks. Therefore, changes to this rate will filter into the overall economy.

Open Market Operations

The Large Value Transfer System (LVTS) is the framework for the Bank of Canada's implementation of monetary policy. It is through this framework that Canada's commercial banks borrow and lend overnight money to each other in order to fund their daily transactions. The LVTS is an electronic platform through which these financial institutions conduct large transactions. The interest rate charged on these overnight loans is called the overnight rate or bank rate. The BoC can manipulate the overnight rate by offering to lend at rates lower or higher than the current market rate if the overnight lending rate is trading above or below the target banks.

On a regular basis, the bank releases a number of publications that are important to follow. This includes a biannual Monetary Policy Report that contains an assessment of the current economic environment and implications for inflation and a quarterly Bank of Canada Review that includes economic commentary, featured articles, speeches by members of the Governing Council, and important announcements.

Important Characteristics of the Canadian Dollar

• Commodity linked currency. As the world's fifth largest producer of oil and gold, Canada's economy is highly dependent on commodities. This creates a strong positive correlation between the Canadian dollar and oil prices. Generally speaking, when oil prices rise, it benefits domestic producers and increases their income from exports. However at the same time, strong commodity prices can hurt growth abroad; so while rising oil prices are initially positive for Canada, the negative impact on global growth could lead to a decline in demand over the medium term. On the flip side, falling oil prices are negative for the Canadian dollar; but if prices remain low and global growth benefits, it can eventually neutralize the negative impact.
• Strong correlation with the United States. Since the 1980s, Canada has been running merchandise trade surpluses with the United States and now approximately 77% of Canadian exports are bound for the Untied States. This heavy reliance on U.S., demand makes Canada extremely sensitive to changes in the U.S. economy. As the U.S. economy accelerates, trade increases with Canadian companies, lifting overall economic activity. However, as the U.S. economy slows, the Canadian economy will be hurt significantly as U.S. companies reduce their importing activities.
• Mergers and acquisitions. Due to the proximity of the United States and Canada, cross-border mergers and acquisitions are very common, as companies worldwide strive for globalization. These mergers and acquisitions lead to money flowing between the two countries, which ultimately impacts the currencies. In 2001, the significant U.S. acquisition of Canadian energy companies infused US$25 billion into Canada. This led to a strong rally in USDCAD, as the U.S. companies needed to sell USD and buy CAD to pay for their acquisitions. Any similar type of M&A flow in the future will also have a significant but short-term impact on the Canadian dollar.
• Interest rate differentials. Interest rate differentials between the cash rates of Canada and the short-term interest rate yields of other industrialized countries are closely watched by professional Canadian dollar traders. These differentials can be good indicators of potential money flows as they indicate how much premium yield Canadian short-term fixed-income assets are offering over foreign short-term fixed-income assets, and vice versa. This differential provides traders with indications of potential currency movements, as investors are always looking for assets with the highest yields. This is particularly important to carry traders who enter and exit their positions based on the positive interest rate differentials between global fixed-income assets.
• Carry trades. A carry trade involves buying or lending a currency with a high interest rate and selling or borrowing a currency with a low interest rate. When Canada has a higher interest rate than the United States, the short USDCAD carry trade becomes more attractive; but if the United States embarks on a tightening campaign or Canada lowers rates, the positive interest rate differential between the Canadian dollar and other currencies would narrow. In such situations, the Canadian dollar could come under pressure if the speculators begin to exit out of their carry trades.

Important Economic Indicators for Canada

Canadian economic reports can have a significant impact on the currency. Here are a handful of the most important releases.

Canadian Employment

Every month, Canada releases its labor market report and this report provides more details than that of the United States. Job growth is expressed as net job growth and then split into full- and part-time hirers. Generally speaking, the market prefers that the bulk of job growth is full time, because it represents real long-term employment and not short-term hires that can be laid off at any time. The unemployment rate is also released, and the number of unemployed persons is expressed as a percentage of the labor force.

Consumer Price Index (CPI)

The monthly consumer price report measures the average rate of increase in prices. When economists speak of inflation as an economic problem, they generally mean a persistent increase in the general price level over a period of time, resulting in a decline in a currency's purchasing power. Inflation is often measured as a percentage increase in the Consumer Price Index (CPI). Canada's inflation policy, as set out by the federal government and the Bank of Canada, aims to keep inflation within a target range of 1% to 3%. If the rate of inflation is 10% a year, $100 worth of purchases last year will, on average, cost $110 this year. At the same inflation rate, those purchases will cost $121 next year, and so on.

Gross Domestic Product (GDP)

The gross domestic product measures the total value of all goods and services produced within Canada during a given year. It is a measure of the income generated by production within Canada. GDP is also referred to as economic output. To avoid counting the same output more than once, GDP includes only final goods and services—not those that are used to make another product. For example, GDP would not include the wheat used to make bread, but would include the bread itself.

Trade Balance

The balance of trade is a statement of a country's trade in goods (merchandise) and services. It covers trade in products such as manufactured goods, raw materials, and agricultural goods, as well as travel and transportation. The balance of trade is the difference between the value of the goods and services that a country exports and the value of the goods and services that it imports. If a country's exports exceed its imports, it has a trade surplus and the trade balance is said to be positive. If imports exceed exports, the country has a trade deficit, and its trade balance is said to be negative.

Retail Sales

Retail sales is a monthly national accounts measure that calculates current expenditure by households and producers of private nonprofit services to households. It includes purchases of durable as well as nondurable goods. However, it excludes expenditure by persons on the purchase of dwellings and expenditure of a capital nature by unincorporated enterprises. Stronger consumer spending is positive for Canada's economy and, in turn, the Canadian dollar, whereas weaker consumer spending is negative for Canada's economy and currency.

Producer Price Index

The Producer Price Index (PPI) is a family of indexes that measures average changes in selling prices received by domestic producers for their output. The PPI tracks changes in prices for nearly every goods producing industry in the domestic economy, including agriculture, electricity and natural gas, forestry, fisheries, manufacturing, and mining. Foreign exchange markets tend to focus on seasonally adjusted finished goods PPI and how the index has reacted on a monthly, quarterly, and annual basis.

Figure 33.1 illustrates the 10-year performance of USDCAD

Figure 33.1 USDCAD 10-Year Chart

Source: eSignal