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Andrew Allentuck

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Can the loonie’s surge last?

Andrew Allentuck

 

As I write this column, the loonie is up 24 per cent year to date, a remarkable rise for a currency that hit a low of 62 cents (U.S.) in 2002. What a difference five years can make.

The American dollar, once the world's pre-eminent currency, is now flying low. It's woes are reflected in other major currencies that are soaring. The British pound is up almost 16 per cent year to date, the Euro is up about 12 per cent and the Australian dollar, also a commodity-driven currency, is up 16 per cent against the greenback.

The U.S. dollar is still being held by central banks around the world, which would lose hundreds of billions of dollars if they abandoned the American buck en masse. But as a sign of the times, Bloomberg has reported that Brazilian supermodel Gisele Bundchen has announced that she will no longer accept payment for her runway jobs in American dollars.

How high the loonie may go and when it may return to earth is an issue vital to investors and to almost every part of Canadian business.

The loonie has gained 14 cents (U.S.) since mid-September, notes David Watt, Senior Currency Strategist at RBC Capital Markets in Toronto. It was trading at 85 cents (U.S.) in March this year. The upper boundary of the loonie value has not been established, but for the record, it is far from its all-time high of $2.78 (U.S.), which it hit on July 11, 1864, according to data from the Bank of Canada, which cites valuations based on bank script and notes issued before Confederation by the "Province of Canada."

There are three components to the ascent of the Canadian dollar:

1. The Canadian economy is robust with strong export sales and strong commodity prices. "There is a 90 per cent correlation between the price of oil and the value of the loonie, says Patricia Croft, chief economist for money manager Phillips Hager & North Ltd. in Toronto. The implication: as long as oil is rising, the loonie will follow.

2. The U.S. dollar is weak, suffering from high tax deficits, high balance of trade deficits, and significant war deficit, and, perhaps, the regard the world has for the quality of economic management by the incumbent American administration.

3. Investors have added a speculative margin to the loonie. Currency markets, like commodity markets, are driven by momentum and sentiment. These forces feed on themselves, Ms. Croft notes. In other words, part of the force behind the loonie is just the belief by some of those buying it that it is has a way to go before it tops out.

Yet the rise of the loonie seems to have no upper bound. Around the world, speculators may perceive that there is nothing the Bank of Canada can do about it. "If the Bank of Canada were to lower interest rates, it would have no effect on the exchange value of the loonie," Mr. Watt explains. The BoC is neutral for two reasons, he explains. On job loss, the bank may be neutral. "Ontario may lose manufacturing jobs, but an equal number may be created in Alberta." Any drop in the rate of interest would be inflationary. Finally, short term speculators are not moved by interest rate changes, he adds.

Those speculators have added what maybe 10 to 12 cents of premium price to the loonie, says Adrienne Warren, senior economist for Scotiabank in Toronto.

All this leaves the loonie in what one might call freerise, the opposite of freefall. $1.10 may be a psychological upper limit, Mr. Watt says. But the return of the loonie to where fundamentals may support it will be a long process, he adds.

The long-term mean value of the loonie to the greenback is 76 cents, notes Randy LeClair, Senior Vice-President and global bond portfolio manager at AIC Investment Services Inc. in Burlington, Ontario. "The loonie is now like Nortel at $120. The Canadian dollar will come back to fundamentals."

Which fundamentals is the question. "The reality is that Canada is the only G-7 country with a current account surplus and a federal budget surplus," Ms. Croft says. "We have a 30 year low in unemployment and stable inflation." Those fundamentals attract investment for rather fundamental reasons. The question now is whether Canada can stand a currency with what amounts to a prestige premium.

"We are starting to see the Canadian economy suffer from the rise of the Canadian dollar," says Steve Malyon, a currency strategist at Scotia Capital in Toronto. "We think the loonie may start to back off after a peak in first quarter of 2008 when it could hit $1.12." he adds.

"We think that lower interest rates that may prevail next year will tell speculators to take some money off the table," Mr. Malyon says. "At some point, they will shift their attention elsewhere. On timing, our forecast is that the loonie will be above parity through the end of 2008 and not go back below par. We see the [Canadian dollar] ending 2008 at $1.05 (U.S.)."

Andrew Allentuck writes about investments for The Globe and Mail, and reviews books on finance for globefund.com and globeinvestor.com. He is also the author of several books.

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