Sunny Skies or Stormy Weather? The forecast for the loonie

It matters for manufacturing exporters and crude oil producers. It matters for importers of California wine and specialized machinery. And of course it matters for families planning that long-awaited trip to Disneyland. The value of the Canadian dollar makes a difference.

The loonie returned to parity with the U.S. dollar today for the first time in months. Where can we expect the loonie’s exchange rate to go in the fall?

To answer that question requires a quick summary of the main factors that determine its exchange rate movements.

First, commodity prices. Canada is a natural resource exporting nation and prices for commodities like crude oil, wheat, base metals, gold and potash make a difference. Most of these commodities are priced and sold in US dollars, but sellers then take the U.S. dollars they receive and convert them back into Canadian dollars. The end result is that higher commodity prices raise the demand for Canadian dollars—and the loonie tends to rise.

Second, Canada’s fiscal positions. One reason why the loonie flew so low back in the ‘80s and ‘90s was that Ottawa was running shockingly large deficits and investors don’t look favourably on countries in poor fiscal shape. Today, Canada is one of the best fiscal performers among the G20 countries. Even though Ottawa is still running a deficit, it has a fighting chance of returning to a balanced budget by 2017. Hardly any other developed country can say that—especially not the U.S.

Third, interest rates. Countries with higher interest rates attract foreign investment dollars. Granted, the country has to be stable and without risk of default (sorry Greece). Interest rates in Canada are extremely low at the moment, but the Bank of Canada will likely raise interest rates before the U.S. Federal Reserve. Rate increases in Canada are still probably a year or so away, but the Fed won’t be raising its rates until late 2014. Investors will be watching developments in Canada closely, waiting for signs that rates are going up. And when those signs appear the Canadian dollar will get a lift.

Fourth, trader sentiment. Along with other countries like Australia, Norway and New Zealand, Canada is in a group of countries that are stable and well-run, but are still considered risky by traders. Ours are relatively small currencies compared to the U.S. dollar, the British pound, the yen or the euro. In times of global uncertainty, currencies in these riskier countries tend to tumble.

With those main factors in mind, what’s the forecast for the Canadian dollar in the second half of 2012? There are basically two scenarios that could play out:

Scenario #1: Sunny skies! Europe somehow manages to get its act together and avoids a major banking meltdown. The euro currency holds together. Spain, Greece, Italy and Portugal are in for a difficult decade of slow growth and recession, but they manage to hang with the euro currency. The U.S. and China avoid major downturns and demand for commodities hold up. Investors lose some interest in the traditional safe havens like the U.S. dollar and gold. The Bank of Canada signals that rates will be rising by next spring.

Under this scenario, the riskier currencies like the loonie do well and appreciate against the U.S. greenback. Canada’s relatively good fiscal position attracts investment dollars. Given this, the Canadian dollar would rise back above par and trade in the range of $US 1.02-1.07.

Scenario #2: Stormy weather. Europe can’t squirm its way out of this mess and Greece and Spain default. The euro currency loses members and banks collapse. The U.S. dollar soars as the only remaining safe haven for investors. Recession grips Europe and the U.S. and China are dragged down. Interest rates remain at rock bottom including in Canada. A global recession pounds commodity prices. Oil hits $US 50/barrel. Base metals, potash and gold are also smacked down.

Under this scenario, the Canadian dollar gets sideswiped in the wake of a strong “flight to safety” in the U.S. dollar. The loonie is volatile and falls to the range of $US 0.85-0.95—possibly lower if it appears the global economy is headed for a prolonged recession.

So what is it going to be? Sunny skies or stormy weather? It’s probably a bit of both. While uncertainty will remain high, the chance of scenario #1 is 25 per cent. The chance of scenario #2 is 10 per cent. And the huge chance of it being somewhere in between makes up the difference. This means we’ll see the Canadian dollar stumble around its current range for a while longer, but chances are it will hover close to par this fall and will trade slightly above par in 2013.