CAD — Breaking Records

2007 has been an extraordinary year for the CAD. It has been the best-performing G10 currency versus the US dollar, gaining 15%, and has managed to reach a record level of 0.91. We have to confess that this performance was far better than we had expected early in 2007.

Expected 2007 Outlook

When we published our outlook piece last January, we expected the CAD to underperform other G10 currencies against the USD in 2007. Our rationale was as follows: Given that CAD is already overvalued by more than 5% against the USD according to our models, the scope for appreciation is already limited. Adding to this, the weak growth in 2007, the normalization of the commodity prices coming from weaker global demand and the yield differential between the US and Canada are all factors that would weigh on CAD and are likely to contribute to its weakness. However, our scenario for CAD is not for depreciation against USD. We think CAD will underperform other currencies that are likely to appreciate against USD in 2007. We highlighted a couple of risks to the scenario: On the upside, it seems the market is overly pessimistic on the Canadian economic outlook. Any strong signal could change this point of view and support CAD in the short run, particularly given the large short position at the moment. A sharp increase in commodity prices could also provide some support to CAD. On the downside, a crash in the housing sector or a more severe slowdown in the US would lead to weaker growth and more CAD depreciation.

The Mighty CAD

Contrary to our expectations of last January, the CAD has gained about 15% against the USD, 10% against the EUR, 7% against the JPY and 3% against the GBP. USD/CAD reached a modern-time record value in November; one has to go back to the US Civil War to see USD/CAD at lower levels. According to our fair value models, USD/CAD is now roughly 20% undervalued.

The strong performance of the CAD in 2007 can be explained by two main factors. First, the Canadian economy has continuously surprised on the upside throughout the year. At the beginning of the year, growth for 2007 was expected to be 2.2%. Following three consecutive quarters of higher-than-expected growth, 2007 growth is now estimated to be 2.5%. The first half of the year was particularly strong at 3.6% on average. The very robust domestic demand fuelled by a strong labor market was the main surprise. It was also strong enough to fully compensate for the negative contribution to growth coming from net exports.

Second, commodity prices have continued their ascent. The Bank of Canada commodity price index shows that commodity prices have increased by about 20% during 2007, with the energy component increasing almost 50% due to the sharp rise in oil prices. Strong growth around the globe has been behind this increase. The commodity prices surge has generated a massive terms-of-trade shock in Canada, giving a big boost to the currency.

In addition to the previous two factors, we also need to include increased speculative flows. Stronger growth and high commodity prices cannot explain all of the sharp appreciation of the CAD over the year. This was also highlighted in comments by the Bank of Canada’s Governor David Dodge in November saying that the abnormally rapid appreciation of the currency was not entirely due to improving terms of trade. This point is also supported by the IMM data. From net short in January, investors have gradually accumulated long CAD positions. Net long CAD positions have remained elevated for most of the year and peaked at record levels in November. Since then, they have reduced gradually, as investors are beginning to be more concerned about the growth prospects of the Canadian economy.

What to Expect in 2008

The end of 2007 is likely to give a preview of what we should expect for 2008. The CAD has given back some of its strength, as investors have started to scale back their growth expectations for the US and the Canadian economies. In addition, the Bank of Canada pre-emptively cut interest rates by 25 bp in early December. The BoC’s statement makes it obvious that, despite the strong growth seen in 2007, the combined impact from the sharp CAD appreciation, tighter credit market conditions and weaker US growth outlook will likely slow the Canadian economy in 2008.

Our US economics team recently announced that it expects a recession in the US in 2008. This should have a major impact on growth in Canada. As mentioned previously, at no other time during the past decade has the Canadian economy been better placed to withstand a US recession than it is now (see “CAD: If the US Sneezes, Will Canada Catch a Cold Again?” FX Pulse, Sept 6, 2007). However, there is always a risk that the weak growth in the US could drag the Canadian economy into a recession. In reaction to the slowing economy, the BoC is likely to continue cutting interest rates. Weaker growth in the US and the likely spillover to the world economy will likely mean lower commodity prices going forward, which would reduce the terms-of-trade gains enjoyed by Canada over 2007.

All these will likely be negative for the CAD in 2008. We suspect that the CAD will mainly depreciate against countries that are less sensitive to the US outlook (like the Australian dollar, which is linked to the Asian economy). We also think that the CAD could depreciate against currencies such as the Swiss franc that could benefit from a safe-haven status when growth in the US slows more markedly.

By Charles St-Arnaud London
Morgan Stanley
December 16, 2007