Intervention Threatens The Loonie

When the U.S. sneezed, Canada - like the rest of the world - caught its cold. And the currency of this key U.S. trading partner has since become a victim of the ebb and flow of global risk appetite.

For instance, last year, when uncertainty was high and money fled to the center of the global economy, the U.S. dollar and the Canadian dollar fell sharply.

Now that risk appetite has returned to the global financial markets and money is flowing back out of the U.S. dollar, Canada’s loonie has had a strong recovery. In fact, the Canadian dollar has rallied 20 percent against the U.S. dollar from its weakest point last March.

As for the economy, recovery is on track in Canada. But Canadian officials are worried about the recent strength of their currency. They’re concerned it has already dampened the path to recovery and could ultimately derail it.

Intervention Threats …

The governor of the Bank of Canada (the nation’s central bank) has said that a stronger Canadian dollar was a major risk to economic growth. And the Canadian finance minister has signaled that steps might be taken to dampen the volatility in their currency.

The loonie has had a strong rally. Now the government is threatening intervention.

These are huge statements - attempts to influence market sentiment. Of course, the next step is physically doing something about it.

Official intervention is when a central bank (or an agent of the government) buys or sells foreign currency in an attempt to influence exchange rates. In the past, many governments have intervened in foreign exchange markets to try to:

• Stop the appreciation of their currency,
• Defend against the depreciation of their currency,
• Or to simply slow the movement of its currency.

As you can see in the chart below, the Canadian dollar (the white line) has been dragged around by the “risk” trade and has been tracking the performance of the S&P 500 (the orange line) very tightly.

Source: Bloomberg

The S&P 500 (^GSPC: 1034.54 +8.41 +0.82%) has been the proxy for risk appetite and perception of economic recovery in the U.S. As optimism about the outlook for a global recovery has gradually improved since March of this year, so has the strength of the stock market … and, therefore, so has the strength of the Canadian dollar.

Fundamentals Point In Canada’s Favor …

The big Canadian banks managed to mostly steer clear of the load of toxic assets that crushed American and European banks. Its banking system was considered the world’s soundest last year … they required no new capital and remained profitable.

Canada implemented a $32 billion stimulus package to boost its economy.

Even so, Canada recognized the exposure of its economy to the growing global recession and acted aggressively in coordination with five other central banks to begin slashing interest rates down to near zero. In addition, Canada rolled out a fiscal stimulus package.

Still, the economic consequences from recession have been harsh for Canada, as a neighboring country that relies so heavily on the health of the U.S. economy.

Indeed, the IMF expects Canada to contract 2.3 percent and then return to an anemic 1.6 percent growth next year. Those forecasts are expected to outperform the U.S. in both 2009 and 2010.

On a relative basis then, the Canadian dollar should be outpacing the U.S. dollar. But currencies aren’t trading on relative growth right now. It’s all about the risk environment.

So if you think the fundamentals of the recovery are robust, you might expect global stock markets and the Canadian dollar to go higher. Alternatively, if you think that there are growing question marks about the sustainability of the recovery, you’re anticipating that investors will rein in risk, and stocks and the Canadian dollar will go lower.

For clues, let’s look at …

The Technical Picture For the Loonie …

Below is a weekly chart of the U.S. dollar/Canadian dollar exchange rate. You can see the tight downtrend from 2001 to 2007.

For Elliott Wave aficionados, this chart looks very interesting. The five wave downtrend is now being corrected through an impulsive A-wave, a corrective B-wave and a potential impulsive C-wave that projects the U.S. dollar/Canadian dollar exchange rate toward the $1.50 mark.

In others words, the technical set-up indicates a rising U.S. dollar and a sinking Canadian dollar.

Source: Bloomberg

The technical picture creates a viable bearish scenario for the Canadian dollar. And with the added element of intervention talk, betting on a lower loonie makes for an attractive risk/reward trade.

To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive.