10/05/2011 08:55 EDT | Updated 12/05/2011 05:12 EST

Don't Panic Over the Loonie's Tumble

A weaker currency makes Canadian products more affordable for U.S. consumers. This factor alone may not be enough to offset demand-driven losses, but it could soften the blow.

Flickr: TMAB2003

On Wednesday, the Bank of Montreal released an advisory suggesting the Canadian dollar could fall to 93 cents U.S. within the next three to six months. According to BMO, the dollar will continue to depreciate on weaker global commodity prices expected to persist over the next two quarters.

The Canadian dollar is closely tied to commodity prices. This is due to Canada's position as a leading exporter of resources including oil and natural gas, timber, and metals and minerals. Canada is also a major supplier of manufactured goods including automobiles, heavy equipment, and aircraft.

By the end of July of this year, the Loonie was trading at a year-long high just slightly below $1.06 U.S. but this all changed as the equity markets entered into a pronounced sell-off. As prices continued to plunge, the Loonie tumbled to less then 97 U.S. cents by the end of September.

Over 70 per cent of Canada's exports find their way to the American market -- this is one of the advantages of having the world's largest economy as a next-door neighbour. However, this also means that the health of the U.S. economy can have a tremendous impact on Canada's economy.

The debt crisis in Europe is also contributing to an appreciation in the U.S. greenback. With the Eurozone entering into what appears to be a new, more dangerous phase, the heightened uncertainty is causing nervous investors to abandon the euro for the safety of the dollar.

On a more positive note, a weaker currency does make Canadian products more affordable for U.S. consumers. This factor alone may not be enough to offset demand-driven losses, but it could soften the blow.

Through much of the 1980s and 1990s the Canadian dollar was routinely valued well below its U.S. counterpart. This benefitted exporters and many American manufacturers even set up production facilities in Canada to take advantage of the exchange rate premium between the two currencies.

This is not to say that the Bank of Canada wants a return to the days of a 70 cent dollar; but there is also no reason to expect the Bank to be in a rush to boost the Loonie. The Bank could increase demand for the Loonie by raising interest rates making the currency more attractive for investors, but higher interest rates would have a dampening effect on growth. With the weaker outlook in the last Bank of Canada statement, concerns for the overall economy take precedence over exchange rate worries so expect the Bank to resist an interest rate hike.

Looking ahead six to nine months, the BMO report expects the loonie will hold around 93 cents until mid-way through 2012. During the second half of the new year, growth is expected to accelerate leading to a recovery in commodity prices. Based on this assessment, BMO predicts the Canadian dollar will be very near parity by the end of next year.