Improved cyclical outlook pushes USDCAD towards fair value
- The Canadian economy is set to benefit from US fiscal-driven growth but will not experience the same deterioration in twin deficits as the US over the longer term.
- Cyclical currencies like the Canadian dollar tend to benefit from strong global growth and rising commodity prices in a reflationary environment. Funding this trade out of euros amplifies these cyclical positives.
- The Canadian dollar has appreciated substantially this year and we believe it is now approaching fair value versus the US dollar. While our longer-term models remain overweight, we have begun scaling back exposure.
Why the Canadian dollar is outperforming the US dollar this year
Global longer-term interest rates have risen sharply in 2021 in anticipation of additional fiscal stimulus in the US, and on hopes for an economic rebound as Covid vaccination programmes ramp up. Although the US is among the markets with the most significant interest rate repricing, the implications for the US dollar have been complicated by offsetting positive cyclical factors and negative structural factors. This has led to periods of underperformance and outperformance of other developed market currencies. So far this year the Canadian dollar has been consistently strong. We examine why the Canadian dollar is so well positioned for expansionary US fiscal policy.
During periods of strong global growth, cyclical currencies tend to outperform the US dollar – even when the US is the largest contributor to the strength of the global economy. This happens because the US dollar is a key source of funding for global debt markets and US Treasuries are the world’s safe haven asset; therefore, in an environment that is favourable for risk assets, the US dollar will typically underperform as money flows into higher beta global assets (Exhibit 1).
Exhibit 1: Currency Sensitivity to Growth Environment
Other low-yielding reserve currencies have also been under pressure as a result of the strength of global growth and the rise in global yields. We have favoured the euro as a funding currency both for its low beta to global growth and due to the slow vaccination and re-opening efforts in Europe that are resulting in a less favourable growth outlook for the eurozone.
A key feature of the post-Covid economic optimism is the boost it is providing to commodity prices. This is a result of synchronised economic expansions around the world and years of low investment in new capacity for many commodities, along with inflation expectations rising as a result of massive fiscal and monetary stimulus. Canada specifically benefits from the rise in oil prices as a major energy exporter, but it also has exposure to commodities, such as lumber, that are experiencing historically unusual rises.
While the near-term growth outlook for the US is, without doubt, impressive, there remain some questions around the longer-term risks from such large twin fiscal and current account deficits. With rates still historically low, even after the recent rise, the fiscal position is not at a stage that questions the creditworthiness of the US. However it is likely that maintaining large fiscal deficits as private savings return to more normal levels will exacerbate external deficits that weigh more directly on the currency. In contrast, while Canada has also suffered some fiscal impairment as a result of the Covid shock, overall debt metrics remain more favourable and the external balance is gradually improving (Exhibit 2). US fiscal spending could turn out to be an ideal policy for Canada, providing growth benefits via close economic links, but without the associated longer-term debt.
Exhibit 2: Current Account (% GDP)
The Canadian dollar is approaching fair value
For all the positive factors we see supporting the Canadian dollar, particularly against the euro, we acknowledge that market pricing has changed substantially since the start of the year. Our longer-term valuation metrics now point to the Canadian dollar being close to fair value from previously undervalued levels (Exhibit 3). The extent of rate normalisation discounted into the Canadian yield curve also looks optimistic relative to other developed market peers. As a result, we have decreased some of our exposure. As ever, we continue to weigh the impact of shorter-term technical factors against the supportive medium-term fundamental factors and seek to add value through actively managing our exposure around this constructive longer-term outlook.
Exhibit 3: USDCAD Spot Price Vs PPP