What’s behind recent strength in the Canadian dollar?

(Photo by KMR Photography; Flickr; CC BY 2.0)

On Friday, the Canadian dollar rose nearly a cent relative to the U.S. dollar.

The sudden ‘strength’ came from a couple of sources. First, more confidence that the Bank of Canada will continue the path gradual rate hikes; second, a weaker U.S. Dollar.

Recent Canadian economic data warrants the Bank’s outlook for gradual rate increases. Especially as Stephen Poloz, the governor of the Bank of Canada, has made it clear over the last month that the Bank will continue to make ‘data dependent’ decisions even in the presence of trade uncertainty. While the Bank will take into account the risks of trade and consumer credit risks, the economic data released on Friday was optimistic. Agree or disagree with the rate hikes, we can’t do much more than follow the narrative from the Bank.

You may know the story well by now. The Bank of Canada hikes rates to control inflation and avoid the prices of goods rising uncontrollably above long-term target of 2%. Inflation is a result of economic strength. When more consumers come to the table competing to buy goods, prices go up. As farmers you manage businesses. What happens when more people want to buy your crops than what you have? Prices (should) rise.

In June, Canada’s ‘headline inflation’ rose to the highest level in six years at 2.5% year-over-year. This was above market expectations of a 2.4% rise, and up 0.3% from May’s 2.2% reading. Core inflation remained unchanged, year-over-year, from the April reading of 1.3%. Headline inflation is a general reading and core inflation is a reading that excludes volatile goods such as energy and food. Rising inflation in an economic environment of rising interest rates provides confidence to the Bank of Canada that it did the right thing by hiking rates over the last year.

That being said, inflation is a delayed reaction to economic strength. Prices of goods tend to rise over time, not simultaneously with the onset of a strong economy.

Along with the rise in inflation, retail sales in May grew by 2% month-over-month following Aprils 0.9% decline. The major push higher was the automobile and parts sector where sales grew by 3.7%, nearly retracing all of the 3.8% decline observed in April. May’s retail sales growth was 1% above what the market anticipated.

Simply put, Friday was a day of strong economic data increasing interest rate hike outlooks, and in turn the demand for the Canadian Dollar. But the CAD/USD currency pair has two sides – the demand of the Canadian Dollar and the demand of the U.S. Dollar – and, broadly, the U.S. dollar finished the week under pressure.

The White House (really Donald Trump) has been very expressive over the last few days with increasing threats towards China and directed pokes at both Canada and the European Union. But his expressive opinions have not been isolated to external disagreements. On Thursday Trump also started an internal fight with the Federal Reserve Chair, Jerome Powell.

Trump openly admitted he is not a fan of the interest rate hikes from the Federal Reserve. In his view the hikes, which do slow down the heating economy, are taking back all the hard work he is doing to bolster the U.S. economy even further. This comes only a day after Powell, the Federal Reserve Chair, mentioned that trade wars do not fare well for the economy if history provides any narrative.

Since the trade rhetoric picked up in mid-April the U.S. Dollar Index (which measures the broad strength of the currency) has risen over 6%, even after Friday’s 1% decline. And Trump, whom seemingly flip-flops opinions, is not a fan of the strength the U.S. dollar has had in the recent months.

In the last week Trump has accused China, the European Union, and others of manipulating their currency lower. His view is that this is ‘not a level playing field’ as it takes away the competitive advantages of the U.S.. China, for example, openly continues to weaken their currency in an attempt to offset the potential economic damages tariffs could have.

Trump believes that higher interest rates in the U.S. are offsetting all the work he is doing to ‘Make America Great Again’. Will the interest rate hikes in the U.S. stop? Well, if the economy continues to grow at the pace it is, interest rates won’t slow down. The Federal Reserve has hiked rates twice so far in 2018. And the market is pricing in nearly a certainty for a third hike and more than a coin toss for a fourth.

In a world of uncertainty where will money move? At the current risk free-interest rates the U.S. is offering, and the outlook for higher returns, the U.S. Dollar is the safest bet over the last two months. Out of all countries involved with trade disputes the U.S. economy has the best cushion to absorb any fall. From the outside looking in, if you fear a global economic collapse, what currency would you put your money in?

Currencies that risk declining interest rates as a result of economic damages from trade? Or, a currency that has aggressively hiked rates, in tandem with economic growth, that has no immediate signs the trend will slow down? Despite Friday’s decline the U.S. dollar remains the frog at a party of toads.

We are in interesting times. And, frankly, everything I just discussed could be negated with one Trump comment or unexpected resolution quickly moving money around markets. The Canadian dollar will continue to be under pressure, relative to the U.S. dollar as long as the trade uncertainty persists. But, how much depends on U.S. dollar’s broad strength or weakness which will partially be influenced by the path of other trade disputes.

Some food for thought for grain prices. Is a higher Canadian dollar bad if it is a result of a weaker U.S. dollar?

In today’s grain futures markets any positive fundamental could offer confidence that futures have ‘bottomed’ and a weaker U.S. dollar would be an asset. At the expense of a potentially higher Canadian Dollar and a hit to basis. A stronger Canadian dollar as a result of strong Canadian economic data and interest rates, however, is a hit to basis with no effect to the broad value of the U.S. dollar and grain futures.

As Canadian producers, in these uncertain times with lower grain prices, it is important to pay attention to why the currency has moved rather than how much it has moved.

 

Matthew Pot

Matthew Pot is an Ontario-based economist and the author of Grain Perspectives. You can follow him on Twitter at @MatthewPot, and subscribe to his daily Grain Perspectives newsletter here.

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