FX Update

HEADNOTE

Canada: Speed Limits and Misalignments

The Canadian dollar's rally this year has exceeded even the most bullish expectations. On September 20, USD/CAD broke below parity for the first time in 30 years on its way to the lowest levels on record

since the US Civil War. The looneys strength is understandable given Canada's strong economic fundamentals, a doubling of crude oil prices this year and a rapid improvement in interest rate differentials with the US. However, the looney is looking increasingly overbought against the greenback judging from the pace of recent gains. USD/CAD has fallen 22.3% since the beginning of the year, reaching a low of 0.9059 on November 7. This not only raises concerns about the currency's overvaluation, it is also raising concerns that the looney is becoming increasingly misaligned.

In order to determine historical norms for an "orderly decline," we examined daily price movements for all G7 currency pairs since 1980. The results were striking. In no instance has a G7 currency fallen by more than 30% for any 12-month period since 1980. Moreover, the only instances in which a 20% devaluation was recorded, apart from the Plaza Accord of 1985, were the 22.8% ERM-related devaluation of the ITL against the USD and JPY in 1992 and the 22.8% decline in the EUR against the JPY in 1999 following its launch. Otherwise, no G7 currency has been allowed to fall by more than 20%. The coordinated devaluation of the USD following the Plaza Accord of 1985 is useful for determining what tJie G7 considers the limit of an orderly decline. The USD fell -22.4% against the DEM in 1985, -21.4% in 1986 and -18.3% in 1987.

The informal "speed limit" for an orderly decline of a G7 currency appears to be 20% a year. Using last year's closing level of 1.1659, USD/CAD reached its 20% "speed limit" at 0.9330 by the first week of November. The question now turns to whether the looney is becoming misaligned against the US dollar, the currency of its chief trading partner. If so, it will have negative consequences for the US, Canada and global economies. BOC Senior Deputy Governor Paul Jenkins recently remarked that if the Canadian dollar's rise persists, it will pose significant risks to the Canadian economy. In the same interview, Jenkins pointed out that FX intervention is unlikely to have any lasting effects unless followed up with policy action. If crude oil prices don't correct soon, the Bank of Canada may be forced to cut interest rates in order to curb the pace of USD/CAD's decline. A sustained break in crude oil prices above $100/bbl and the resulting move in USD/CAD below the psychological 0.9000 barrier would seem to make this a near certainty.

SIDEBAR

The looney is looking increasingly overbought against the greenback judging from the pace of recent gains. This raises concerns that the looney is becoming increasingly misaligned

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By: Michael Woolfolk, Senior Currency Strategist