The risk-off trade that has permeated global capital markets through the summer and which have re-intensified this month, has counted among its victims the Canadian dollar. Where only in late July the Loonie was trading north of US$1.06, recent selling pressure has taken the buck down below 98 cents (testing 97-1/2 cents this Thursday).
At these levels, we have retraced all of the improvement made since October of last year and, in doing so, retraced more than a quarter of the entire move from the March 2009 low of 76.55 cents. What I have found almost humorous is how individuals have asked me about this latest malaise in the Loonie from the standpoint of it being a concerning development. I say humorous because for the longest time, few people ever expected the currency to reach parity with the U.S. greenback, let alone exceed it. At the same time, a high 90 cent dollar is not going to be the savior for Canada's manufacturing and export sectors.
It would be a mistake to extrapolate this near 10 cent slide in the Loonie to those recession lows of a couple of years ago, mainly because the economic fundamentals that knocked it so sharply lower in 2008 were different than the drivers behind market instability today. Credit conditions in North America are healthier these days for one, even though we have just come off a week which saw three of the bulge bracket U.S. banks (Bank of America, Citigroup and Wells Fargo) get their credit ratings snipped by Moody's. The reason now is concern over that the U.S. government may indeed allow a major institution to fail in a subsequent crisis. That said, these same conditions are playing a role in boosting the safe-haven appeal of the U.S. dollar as nervous money heads to U.S. government bonds.
This flight of capital was given a further prod this past week as the Federal Reserve announced that it would dust off a tool that it hasn't used for about 50 years -- the yield curve "twist," in which it announced plans to sell $400 billion worth of short-dated treasuries and then buy back in the same amount in bonds with maturities greater than six years. Still, when long-term yields are record lows (the 10-year dropping below two per cent), and the two year note sitting less than a fifth of a per cent from zero, there is limited room to go to the downside. In contrast with the 2008-09 market correction, the Loonie has not tracked alongside the recent flows into U.S. bonds to the same extent. To steer the currency even lower, we would need to see additional evidence of a fresh global economic recession and resulting deterioration in those things which help drive the Loonie, namely commodity prices.
Let's keep in mind also that the fundamentals behind the U.S. dollar are hardly positive. This is a short-term phenomenon of capital chasing greenbacks, whereas Washington's fiscal challenges remain high going into the 2012 elections. Canada, with its superior fiscal position relative to not only the U.S., but also most of Europe, remains on the radar screens of global investors looking for a viable currency to diversify into once the U.S. dollar starts to lose its safe-haven appeal. That doesn't mean the Loonie can't shed a few more pennies before that diversification trade kicks in. On a purchasing power parity basis, the Loonie is still about 14 per cent overvalued to the greenback, so technically a slide down to the 90 cent area is not out of the cards. The problem in using such estimates of fair value is that they only take into consideration inflation differentials between Canada and the U.S. In this environment, relative fiscal fundamentals would imply that the Loonie's fair value might be closer to parity.
For snowbirds looking to make their annual sojourn to southern U.S. climates, this recent weakness in the canuck buck couldn't have come at a worse time. And who's to say that the 'temporary' lift in the U.S. dollar won't continue into the fourth quarter. My advice for those who are going to be looking to convert Loonies for greenbacks is to stagger those purchases over the next few months, in case this temporary move proves more 'temporary.'
From an investment perspective, this is not the time to start hoarding U.S. dollars either. Where we have U.S. equity, the prudent approach is to use C$ hedged instruments (exchange traded funds or mutual funds) where possible. As for bond investing, one should avoid those denominated in U.S. dollars. If we see a return to recent highs against the U.S. greenback, then we can revisit strategies such as buying individual U.S. dollar-based securities. For now, the next time someone complains on how low the Loonie has slipped these past days, remind them that it was only ten years ago that the currency was flirting with 60 cents. And until the fundamentals really start to erode, this can be seen as a partial eclipse in the currency.