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Digesting Currency Changes: The High Flying Loonie

Erica Stephenson - Jun 17, 2021
Over the past year, the Canadian dollar (CAD) has been gaining strength. By the end of May, it had appreciated to reach a six-year high above  0.83 U.S. dollars (USD). What's driving the loonie's flight?
Canadian dollars

Over the past year, the Canadian dollar (CAD) has been gaining strength. By the end of May, it had appreciated to reach a six-year high above  0.83 U.S. dollars (USD). What's driving the loonie's flight?

Strong demand for commodities, along with the continued belief that interest rates will remain low, has helped to push up the CAD. This is quite a contrast from just over a year ago, when oil futures prices briefly turned negative in April 2020 and the loonie fell to a low of around 0.69 USD. The CAD is largely impacted by commodities prices since Canada earns a large portion of its USDs fro the sale of oil and other natural resources.

At the same time, the USD has been losing its lustre. Significant U.S. Stimulus actions have increased the money supply, creating concerns about future inflation and placing downward pressure on the greenback. With near-zero interest rates and a yield on U.S. government bonds closer to that of other developed nations, this has helped to reduce demand for U.S. Treasury's and further weaken the USD.

Will the loonie continue its upward flight? The "Big Mac Index" provides some food for thought. Published by The Economist magazine, its is a fun tool to make exchange rate theory digestible by comparing the purchasing-power parity (PPP) of global currencies. PPP suggests that over the long run, exchange rates should adjust so that an identical basket of goods/services costs the same in each country. Instead of using a basket of goods, it creates an exchange rate by comparing the cost of a Big Mac hamburger in a nation's currency to its cost in the US. Comparing this to the prevailing exchange rate determines whether a currency is considered under or overvalued. The bar chart shows the under/over valuation of the CAD versus the USD based on the Big Mac. The actual exchange rate is shown on the grey line. In January, the model predicted that the CAD was undervalued.

Currency fluctuations area  normal part of the financial markets. While a stronger CAD may provide better buying opportunities on U.S. assets, for longer-term investors the impact of currency changes on returns often has the tendency to even out over time.