The Canadian dollar has broke through some interesting points this past week.  On Tuesday, it hit 14-month highs, climbing up 3.5% over the past 7 days – which is quite a bit in currency terms.  The loonie is also up against all 16 major currencies.  All of these data points have analysts speculating that the loonie might reach parity with the greenback much sooner than expected.  The question is, how high will it go, and how long will this run last?

Historical Highs and Lows of the Canadian Dollar Against the USD

Factors Driving the 6-month Rise in the Canadian Dollar

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BNN economist Linda Nazareth points out the four major reasons the loonie is going up and unlikely to encounter any significant obstacles in the near term.

1.  US Dollar Weakness.
Both US currency and US economic fundamentals remain weak and show no signs of strengthening in the near term at all.  The national debt and both deficits are rising, the money supply is growing, and the Fed will not be raising interest rates as long as unemployment remains low and the economy shows no signs of real growth.

2. Commodity Prices Rising.
Canada is a resource nation and the Canadian dollar is a commodity currency.  Often the loonie is driven by energy prices, but recently it is gold and gold’s new highs (today breaking through $1070/oz.) that have the loonie spiking higher.  You might want to take a look at the world’s largest gold stocks or Canada’s top 20 gold stocks.

3. Improving Canadian Fundamentals.
The Canadian economy is bouncing back.  Especially following last Friday’s positive jobs report, investors and traders are coming back into the Canadian dollar as opposed to other currencies.  Further, Australia’s recent rate hike suggests to some that the Bank of Canada might be following behind, if not soon, at least sooner than mid-2010.  If you’re bullish on the Canadian economy in general, take a look at Canada’s income trusts for monthly yields often tied into the energy and real estate sectors.

4. Reserve Currency Diversification.
Many central banks around the world are diversifying the currencies they keep in reserve.  Rather than hold a majority of their wealth in US dollars, they are opting for currencies that pay more in interest – such as Australia, and now perhaps Canada, too, for the reasons laid out above.

When To Buy US Dollars and Take Advantage of the USD/CAD Exchange Rate

Factors That Might Hold the Loonie Back

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Fair value for the loonie, according to Sebastien Galy, securities analyst at BNP Paribas, is usually between 80 cents and 1.00 USD – breaking through parity will definitely overvalue the Canadian dollar and hurt Canadian exports.  According to Galy, exporters will just now be starting to feel some pain.

So will the Bank of Canada intervene? According to these analysts, all the Bank of Canada can do at this point is “jawbone” the loonie down by openly talking about intervening.

The best way for the Bank of Canada to intervene would be to buy a ton of US Treasuries (China’s preferred strategy for keeping the yuan artificially weak), but no one expects the Bank of Canada to do this – or other European banks – due to the inherent weakness in the US dollar, which would make their investments’ value drop.

The Bank of Canada also isn’t expected to raise rates, although commodities prices are putting it under pressure to do so, because raising rates would only exacerbate the problem by further strengthening the currency.

What Makes the Loonie Rise and Fall Against the Greenback

The US Dollar Weakness Paradox – It Cuts Both Ways

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Central banks around the world don’t like the US dollar weakness for two reasons.  I’ll give each one with its obvious (but perhaps not so simple) solution.

1. It makes their country’s exports more expensive to the U.S. market, which is often one of the biggest trading partners.  This is the central reason for countries playing the “competitive debasement” game with the Fed.  Solution? Diversify your trading partners and export markets.  It is possible.  Take China’s lead.

2. It lowers the value of the wealth they hold in US dollar reserves.  These reserves will be held in the form of US Treasuries, T-bills, notes and US government bonds of various sorts.  This is why China is so concerned about the quality of the US debt it holds.  Each time the US holds a treasury auction, the value of existing US debt instruments falls.  Solution? Diversify your currency holdings slowly over time.  This will be easier if #1 is also put into place at the same time.  Again, follow China’s lead.

World Bank Warns Not To Take USD Reserve Status For Granted (Sept. 27, 2009)

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