Bank of Canada Hints at Exchange Rate Volatility

Canada was founded on, and remains highly dependant upon, its exports. In addition to being blessed with an abundance of resources craved by all industrialized nations, Canada also has the good fortune to share a 3,000 mile long border with the greatest consumer of these products on the planet. Little wonder then, that Canada ships the bulk of its exports south to the United States as part of a bilateral enterprise exceeding $1.5 billion USD a day.

The trade relationship between Canada and the US is the envy of the world, with Canada exporting 70 to 80 percent of its total exports to the United States. Such a dependency has a downside however as the bottom line tends to suffer when your primary trading partner succumbs to a deep and protracted recession. Changes in exchange rates can also affect trade values as any increase in the value of the exporting nation’s currency has the immediate effect of increasing the cost of the exported goods, potentially leading to declining sales. Without question, the Canadian dollar’s history of trading at a bargain to the US greenback is one factor that helps Canada maintain a trade surplus over the United States, but this advantage could be soon coming to an end.

Nick-named the “loonie” in homage to the large waterfowl depicted on the back of the $1 coin, the Canadian dollar has gained recently on the strength of the rebound in commodity prices. While higher prices for its exports can help boost the economy, Canada’s exporters fear that an appreciating loonie could push the currency to parity with the US dollar – and unlike the last occasion when the loonie reached parity in the fall of 2007 – the worry is that the loonie will remain dominant over the US dollar for more than just a few weeks. Cue ominous warnings from the Canadian government and the Bank of Canada.

Canada’s benchmark rate is already at a historic low of 0.25 percent; the direct result of the Bank of Canada’s efforts to boost the economy during the height of the recession. The government also played its role to help the economy by supplying billions of dollars in the form of direct stimulus spending, but the combination of low interest rates and a surge of cash have some worrying about inflation. This threatens to put the Bank of Canada in a difficult position with respect to setting future interest rates.
When economies need a boost, Central Banks lower interest rates to make loans cheaper in a bid to encourage spending. This tends to weaken the value of the currency as those holding long positions in the currency, will receive lower interest payments. This may tempt investors to sell the currency in favor of higher yields available with other currencies.

On the other hand, if growth appears to be gaining too quickly, central banks can tighten the money supply by increasing interest rates. This makes it more expensive to borrow money, causing corporations and individuals to hold off purchases and slowing growth to more sustainable levels in line with the Bank of Canada’s target of two percent annual growth.

The problem for an exporting nation like Canada however, is that increasing interest rates usually leads to an appreciation of the currency, resulting in a jump in the cost of exports for nations whose currency is not appreciating at the same rate. Again, because Canada conducts the majority of its trade with the United States, the fact that the US dollar is particularly weak right now, with little expectation of a change in direction in the near future. Thus, the Bank of Canada could be facing a difficult decision in the coming months – a choice between keeping the dollar weaker and accepting higher inflation, or increasing rates to keep inflation in check at the expense of exports.

Bank of Canada Governor Mark Carney drew attention to the prospect of higher interest rates in a speech in Vancouver last week when he referred to the Bank’s earlier pledge to hold the benchmark rate at 0.25 percent as “conditional” on growth and inflation targets.
“Policy makers will have to act deftly to maintain stimulus long enough for private demand to take up the burden of growth, but not too long to undermine confidence in and the sustainability of that growth,” Mr. Carney said. “The aftermath of the crisis will make considerable demands on structural policies in all countries, including Canada.”

The warning could not be more obvious and currency traders in particular should brace themselves for the likelihood of increasing exchange rate volatility. If actual growth exceeds the targeted thresholds, expect a quick response in the form of interest rate hikes from the Central Banks.

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