Canada looking toppy

Since late May, the U.S. dollar/ Canadian dollar currency pair (USD/CAD) has trended solidly lower,
falling from the $1.40 area to the $1.24 level, signaling a significant strengthening in the Canadian currency. The reason is simple: Overall, the Canadian economy has performed better in 2004 than most economists expected. Exports grew beyond initial forecasts, which supported GDP growth, while inflation levels remained low.

After posting economic underperformance vs. the U.S. dollar a year ago, some analysts now expect Canada to outperform in 2005. The Bank of Canada recently issued a revised growth forecast for 2005, putting GDP growth just under the 3.0 percent mark, which could compare favorably to forecasts for 2.5 percent GDP growth in the U.S. next year.

But beyond that, a number of other bullish factors have supported the gains in the Canadian currency, including a strong trade surplus (in part helped out by higher crude oil prices) and aggressive tightening by the Bank of Canada. However, some wonder how much stronger the CAD can get.

“Canada has a compelling fundamental story…but an awful lot of good news is already factored into the price,” notes Jamie Coleman, managing analyst at IFR/Forex Watch.

After three rate cuts early in the year, the Bank of Canada shifted gears this summer, from an easing stance to a tightening stance. The central bank hiked rates in September and October, boosting the overnight cash rate to 2.50 percent. In its latest statement, the Bank of Canada suggested additional rate hikes could be expected.

An expanding trade surplus, compared with the U.S.’s widening trade deficit, is also another factor in the bullish camp in recent months, analysts say.

“[Canada] already had a trade surplus, but [has] gotten an extra boost from rising commodity prices in general,” says Sean Callow, currency strategist at Ideaglobal.

Canada’s merchandise trade surplus stood at $CD7.4 billion in August, up from year ago levels at $CD4.9 billion. “They are an oil exporter,” explains Dave Sloan, senior economist at 4Cast Inc. “When oil is strong that is a boost to their growth.”

And oil is indeed strong. New York crude oil prices recently hit a new record level at $55 per barrel before pulling back to around $50 at the beginning of November. Adding power to the overall bull
trend in the Canadian dollar is the speculator buying.

“This is a favored speculative trade,” says Callow. “It’s a very liquid market and nobody is fiddling with it. If someone wants to sell the U.S. dollar, you can’t buy China because it’s fixed. With Japan you might have intervention, but with Canada nobody is going to stop you on the other side of the trade.”

Recent data from the Commitment of Traders (COT) report, released by the Commodity Futures Trading Commission (CFTC), backs this up.

The COT report shows the net positions of different classes of traders. Speculators were long 66,500
Canadian dollar futures contracts, the third largest total since October 1992, according to Callow.