Four months ago, in October, the Canadian dollar was worth about US$.97, not quite at parity, but not so far from it either. Today, it is worth about US$.90, a drop of over 7%, and many economists and pundits are saying that it has further to fall. It is unusual for a major currency like ours to fall (or rise) so far, so fast. What’s going on here, and what is the loonie really worth? As with many things in economics, there are a lot of theories, none of which is fully capable of explaining what has gone on, and even less, of predicting what will happen next. However, here are the four main drivers of currency change, all of which are affecting the Canadian dollar to some extent.

In the first place, it is useful to think of a currency in the same way as we think of any other good or service, for example a pound of butter. If demand for butter goes up, the price tends to rise. If the cows are particularly productive and a surplus of butter is produced, the price tends to go down. In the same way, the Canadian dollar responds to supply and demand. The Bank of Canada can increase the supply of Canadian dollars (for example by buying bonds in the open market) and this would tend to drive down the price, making it cheaper for foreigners to buy Canadian dollars, and more expensive for us to buy the currency of other countries. On the other hand, if short term interest rates in Canada were higher than those in the US, there would be a demand for Canadian dollars for investment, and the value of the loonie would rise.

The mobility of wealth and the search for advantage in short term yield can cause significant rises and falls in the day-to-day value of a currency. High interest rates tend to attract money, raising demand for that currency. This “hot money” business is measured in trillions of dollars worldwide. When the Bank of Canada announced that interest rates here would not rise in the short term, and probably not for at least another two to three years, a lot of hot money suddenly departed for more lucrative locations. The sudden drop in demand for Canadian dollars was a big factor in the recent skid.

A second factor that impacts the value of a currency is its relative purchasing power. Imagine that you had US$250 and that you were in a grocery store in New York. You fill your shopping cart, spending all your money. You then drive to Toronto and convert US$250 to CDN$275. You then go shopping in Canada and buy exactly the same groceries. If you can fill your cart with nothing left over using your converted dollars, then the purchasing power of US$250 is exactly equal to that of CDN$275, and the exchange rate in effect (1 US$ = 1.1 CDN$ in this case) is correct. If, however, you find that you cannot fill the cart, then CDN$275 does not have the purchasing power of US$250. Perhaps the exchange rate is therefore too low, and US$250 should really buy CDN$300, not $275. This is the “purchase power parity” theory of currency value. Many economists believe that this is the best way to tell if a currency is undervalued or overvalued.

Canadians know that almost all retail goods cost more in Canada than in the US. This is what gives rise to cross-border shopping. Some surveys show that the real purchasing power of the Canadian dollar is currently no more than USD$.83 or so. If this is true, and if the purchase power parity theory is correct, than our dollar has further to go on the downward trend. However, those skeptical of the theory would point out that this purchase power relative to the US dollar has not really changed much for years, and that despite its weak purchasing power during the past few years, the Canadian dollar has been valued as high as $1.07 US. Obviously, purchasing power parity alone does not tell the full story.

This leads to the third factor in currency valuation: relative economic strength. When an economy is perceived as being strong, its currency tends to rise in value. In Canada, this is usually related to the prices for commodities. We are major exporters of metals including gold and silver; of energy products including coal, oil and gas; and of agricultural products such as wheat and canola. During the first decade of this century, commodity prices were very high. Canada ran a large trade surplus as the value of its exports soared, and our surplus with the US was particularly high. Tax revenues were high and economic growth was good; certainly better than that in the US. All of these factors were involved in the very strong loonie we had in those years.

Now, however, commodity prices have fallen. The US is about to become the world’s largest oil producer, and Canadian exports are threatened by environmental protests, leading to the cancellation or delay of major projects such as the Keystone pipeline. Currency traders sense coming weakness, and are moving funds out of Canada.

Finally, the US is getting its economic house in order. After the huge recession of 2008/09, the US federal government was running a deficit of almost 10% of GDP. Congress and the White House were at daggers drawn, a budget could not be passed, and the US came within days of defaulting on its debt. Things are much better five years later. The US will likely run a deficit of only 3% of GDP this year, a huge improvement. A budget has been passed, and it seems probable that a deal will be reached to extend the debt ceiling. As a result, investors view the US$ much more positively than they did a few years ago. In this case, the Canadian dollar simply loses value in comparison to a more attractive alternative. While our federal government has been fiscally prudent, the same cannot be said of our two largest provinces which continue to run huge and unsustainable deficits. In contrast to the US, suddenly Canada is no longer a shining model of fiscal and governmental rectitude.

Most markets overshoot when they move quickly. It is entirely possible that the Canadian dollar has been oversold at its recent low of $.893 US. However, there is no denying that the major forces that move currencies are all trending against our currency. Where the dollar ends up is, quite literally, anyone’s guess. We have purchased a lot of American stocks in the past two years, and our clients have benefitted from the change in the currency. We are still buying U.S. names, but cautiously, and with an eye towards the value of our dollar. We don’t think we are taking too much risk as we would be very surprised to see a sudden return to parity, or indeed, to a value over USD.096, anytime in the next six to twelve months.