Conclusions: The prudent Governor Carney of the Bank of Canada will continue to raise rates, which should lead to strength in the Loonie versus the U.S. Dollar, especially given the Fed’s Indefinitely Dovish policy.
Position: Long the Canadian dollar (FXC).
Last week we wrote an Early Look note titled, “Pax Canadiana”. While the title was in some jest given that the note was written on July 1st, or Canada Day, it did lay out some key long term trends that will drive Canadian economic growth for decades to come. Interestingly, the trend of global warming (even if just cyclical), is a key component of this as it will attract immigrants and broaden Canada’s agriculture markets. While these long term trends will likely support the Canadian dollar over the coming decades, in the short term the facts that underscore our long position in the Loonie are simply: higher interest rates, fiscal health, and economic stability.
In contrast to many central bankers around the world, Governor Mark Carney of Canada is actually widely respected by his fellow countrymen. In fact, a recent poll in the Canadian version of Reader’s Digest actually ranked Carney as the Most Trusted Canadian. From our perspective, while we are a little concerned that he is a former back-up goalie from Harvard, we actually believe he is a pragmatist that will do the right thing as it relates to inflation.
Earlier this year in a speech in Calgary to the Inter-American Development Bank, Governor Carney made the following comments:
“Monetary policy has to deal with inflationary pressures first and foremost . . . . There are undoubtedly downside risks in the global economy. But if one is dominated by those short-term risks, then you're not going to do the things that are necessary to rebalance the global economy and to sustain it over the mid-to-long term."
In this statement, and other public statements, Carney has been crystal clear about his marching orders, which are first and foremost to stop inflation. Indeed, he has actually followed through on his mission and has raised interest rates three times in the last year, though the Bank of Canada has been on hold since September of 2010.
Below we’ve charted Canadian CPI going back a year, which highlights the recent acceleration of inflation in Canada. In May, Canadian CPI was +3.7%, an acceleration from April at 3.3% and a three month high. While gasoline was a major component of this increase, CPI ex-gasoline was still up 2.4% in May versus 2.2% in April ex-gasoline. Given that the Bank of Canada’s target is to keep inflation in the midpoint of a 1 – 3% range, it seems unlikely that the Bank of Canada will be on hold much longer. In terms of catalysts, the next monetary policy decision dates are July 19th, September 7th, and October 25th.
From a fiscal perspective, we are comfortable being long the Loonie given the relative fiscal health of Canada versus, really, much of the Western world. In fact, Canada has the lowest debt-to-GDP and deficit-to-GDP ratios in the G-8. Further, the current Canadian budget is expected to be balanced by 2015. The difference in these metrics versus the United States is simply staggering. Currently, there is no credible plan in place to ever balance the U.S. budget. So, from a relative fiscal health perspective the Loonie continues to look very compelling.
Finally, while there can be no doubt that the Canadian economy is inextricably tied to the U.S. economy (estimates suggest that the U.S. accounts for more than 70% of Canadian exports and more than 60% of Canada imports), the economies are showing some recent decoupling. In the two charts below, we show this in both GDP and unemployment. For the first time in forty years, Canadian unemployment is lower than American unemployment, and has been sustainably. Further, Canadian GDP growth is beginning to outpace American economic growth rates.
In summation, the collective confluence of a healthier economy, solid fiscal healthy, and a prudent Central Banker who is focused on fighting inflation, should lead to a strong Loonie both against the U.S. Dollar and general currency baskets.
Daryl G. Jones
Director of Research