All Hail the Mighty Loonie!

I was going to right a post about how nutty the Canadian dollar, aka "the loonie," had become.  (For the Americans, yes, we know the singular for loon is "loony." But in our own endearing manner, we have taken the plural spelling and dropped the "s".  Why, I don't know.)  I was going to write that the loonie had come too far, too fast, and that the move looked parabolic and thus dangerous, being a young (okay youngish) curmudgeon and all.

But I wanted to first compare the recent ascent, which began in March, to other rapid increases in the loonie  since it bottomed at $0.6176 on January 21, 2002. 

There have been two other occasions when the loonie shot up like a rocket. 

The first occurrence began on the last day of 2002 and continued to June 16, 2003 when it rose from $0.6328 to $0.7512, a gain of 18.7%. 

The second started on May 18, 2004 and topped out on November 26 of that year, running from $0.7142 to $0.8532, a rise of 19.5%.

The most recent run began on March 5 of this year, and really began to take off as the Fed was madly pumping liquidity into the financial system as a reaction to the sell-off in China and the plunge in stock prices. (Because, as we all know, stocks aren't allowed to go down!) In March, the Canadian dollar was at $0.8459 and hit $0.9554 on Friday (last I checked) before settling a bit lower.  The return during this time, somewhat to my surprise, has "only" been 12.9%.

So, I thought to myself, yes, return has been less but the duration of the change has been much more compressed and thus the daily rate of change has been higher. 

Not at all in fact.  The average daily return during the 2003 run was 0.111%.  In 2004, it was 0.101%.  And this year?  0.103%.  In fact, contrary to my fears and suspicions, this recent leg up has been in line with the two previous ascents.

These three episodes have captured all, in fact more of the entire move in the loonie since it bottomed in 2002.  These three moves in aggregate have returned 60.2% whereas the return from the bottom has been 54.7%. 

Interestingly, there have been nearly 2000 days since January 21, 2002 - 1994 in fact.  However, these three ascents have totaled 487 days.  In other words, a quarter of the time, the market was moving higher and the rest of the time, the loonie was consolidating.  That's healthy bull market behavior.

If the current up leg plays out in a similar fashion, the Canadian dollar will hit par in two or three months.

But is the magnitude of the rise healthy for the Canadian economy?  For consumers, it certainly is as roughly 40% of Canada's economy is dependent on trade with the United States.  However, it is not healthy for the Canadian manufacturing sector, which is heavily reliant upon exports to the United States.

A higher currency should boost productivity (which is sometimes seen, oddly, as a dirty word in Canada as it implies job losses).  As Canada's productivity growth has been relatively low, a higher loonie should bolster the long-term productivity of the Canadian economy as firms will have to operate more efficiently.

However, some are worried the Canadian manufacturing industry will catch Dutch Disease.  So far, there is no evidence this is occurring.   However, that does not mean it will not happen in the future.  At what point does it become uneconomical for the manufacturing base - primarily located in Ontario and to a lesser extent Quebec - to export to the US.  Par?  $1.10?  $1.20?  I don't know, but the loonie's ascent cannot continue indefinitely.

Over the years, I have read pieces by economists who estimate purchasing power parity (PPP) for the Canadian dollar at around $0.75-$0.80.  I haven't read any articles on the subject recently, so perhaps it has changed, I don't know.  That range does seem right by my estimation, however, whenever I compare prices in Canada.  If it is the correct range, then the loonie is overvalued. But then again, using PPP, the loonie was undervalued for much of the 1990s. And as we know, markets can take asset prices much further for much longer than one could imagine. 

My guess is that if the dollar does hit par this summer or fall, Ottawa will start talking the loonie down, perhaps even threatening to drive it down. However, doing so might exacerbate inflation, which would eventually cause the Bank of Canada to hike rates, which would draw in more international capital and thus keep upward pressure on the loonie.

Perversely, Canada finds itself in this quandary because it has done all the right things whereas the US has not.  In the early 1990s, it dawned on Canadians that they were living beyond their means.  Government debt to GDP hit 100%, governments ran chronic deficits and there were fears that the country might hit the proverbial wall as New Zealand previously had a decade prior.  The specter of the IMF setting up shop in the Château Laurier was one Canadians did not want to contemplate. 

So the country set about righting its ship, eliminated its fiscal deficit, and now has a lower debt to GDP than the United States.  Today, it is the only country running a surplus in the G7.  Even better, the political culture has changed.  Whereas the political Left vehemently opposed deficit reduction in the 1990s, arguing it was part of a "corporate agenda," saying it would be better for Canada to default, today, the Left are amongst the most vociferous proponents of fiscal responsibility.  It is a nice change.

Now compare that to the United States, which continues to run deficits during economic expansion when the political Right controlled all the levers of political power.  Also, the Federal Reserve which, for better or for worse, allowed the stock Bubble to get out of hand in the 1990s, and dealt with the aftermath by massive liquidity injections and lowering the Fed Funds rate to 1%, a policy which has devalued the American dollar around the world. 

Because Canada has been more fiscally responsible than the United States, and because Canada is an exporter of commodities which rise in price when fiat currencies are being devalued, Canada is experiencing a rise in its currency. (Of course, the emergence of China and India has increased demand for commodities.)  Now, Canada is caught in a bit of a vice as a policy response would be to lower interest rates to ease the pressure on the manufacturing industry.  However, that would fuel the already out-of-control real estate market in Canada (the global real estate bubble also a result of the Fed's loose policies) which I cannot imagine the Bank of Canada wants. 

So the loonie is going higher.  But there is a breaking point - economically, politically and financially.  That point is closer now than it was a few months ago.