Superbuck falters

Talk about quick-change acts! This month the loonie, which had been doing a marvellous imitation of Superbuck for most of the past two years, suddenly reverted back to its Clark Kent mode, the weak and mild-mannered currency that no one notices.

After passing the US85c mark, it looked as if nothing stood between our dollar and the US90c barrier, and a few economists were boldly predicting par within a year or two.

Then, suddenly, everything collapsed. The loonie tumbled all the way back to the US81c range and instead of talking about par with the greenback the speculation was whether our dollar would stay above US80c or keep tumbling.

My view is that these events represent a temporary retreat in the value of the Canadian dollar, albeit a welcome one. For starters, we need to understand the main reasons behind this sudden reversal. I see three primary factors.

First, the sharp drop in the price of oil. The loonie is to some degree a commodity-driven currency and oil and gas are two of our prime commodities. It would have been a major surprise if our dollar had not been negatively affected when the price of crude dropped so precipitously.

Send, the unexpected shift in the position of the Bank of Canada. Until just a few days before Tuesday’s stand-pat announcement on interest rates, it had been widely assumed that our central bank would tighten the screws by another quarter-point. Not only did the Bank of Canada not do that, but the language of the statement it issued is generally interpreted as indicating that no more rate increases are likely for several months.

This means that the spread between Canadian and U.S. rates is narrowing. The Open Market Committee of the U.S. Federal Reserve Board moved that country’s key rate up another quarter-point on Dec. 14, the fifth increase this year. Rising U.S. rates coupled with static rates in this country make our currency less attractive to Americans.

Finally, the pull-back in the value of the loonie undoubtedly triggered some profit-taking among currency speculators. The resulting sell orders would have added more downward pressure on our buck.

Oil price should result in stabilization
I expect that the price of oil will stabilize in the US$40-$45 range, which means it shouldn’t continue to be a factor in pulling down the loonie. The interest rate picture isn’t clear although if the U.S. economy doesn’t start to create more jobs over the winter, the Fed may decide that a pause is in order there as well. As for currency speculators, they will likely start buying loonies again as they get close to US80c because the longer-term prospects for the U.S. dollar look so grim.

Next page: Implications for Canadian investors

Washington is running a huge fiscal deficit, so large that Congress had to approve an increase in the debt ceiling this fall. George W. Bush was not elected on a platform of fixing the nation’s finances and there is no indication that he views this as a high priority. Big deficits appear to be an integral part of the American equation for the next four years, which will not be beneficial to the value of their currency.

Moreover, a weak U.S. dollar works to the advantage of U.S. exporters – especially if China can ever be persuaded to revalue their currency, which is currently pegged to the greenback. Washington would like to see an improvement in the big American trade deficit and this could be a way to achieve it.

The pull-back in the value of the loonie has two important implications for Canadian investors.

· It eases fears about investing in U.S. securities because of the currency risk. I receive many e-mails from people who are reluctant to buy American stocks because of the fear that any gains will be wiped out by exchange rate losses. That’s unfortunate because the U.S. market is far larger than ours and offers opportunities that are unavailable here. A pause in the head-long rush of the loonie may help to alleviate some of these concerns.

· It reduces some of the pressure on corporate profits. Many Canadian corporations and trusts have reported that profits are lower by millions of dollars because of the high loonie and we are seeing the fall-out starting to show up in job losses. For example, Domtar announced this month that it is cutting some 800 jobs in an effort to deal with the impact of the currency rise. If the loonie would settle into a reasonably predictable trading range, companies would have time to adjust and adapt to the new reality.

There is another important implication to this changing scenario. The Bank of Canada’s decision to put interest rate hikes on hold should benefit the bond and income trusts markets. The S&P/TSX Capped Income Trust Index gained 2.4 per cent in the first half of December. The income trust market looks expensive but this indefinite pause in rate hikes may delay the inevitable correction.

What it all comes down to is that the drop in the loonie should not be a signal to panic. On the contrary, it could turn out to be a healthy development that may open new profit possibilities to those who are prepared to take advantage of them.