Could the loonie be overvalued? Michael Craig, Senior Portfolio Manager, TD Asset Management, talks with Sara D’Elia about what the three drivers of Canadian Dollar currency research revealed last month and how things look interesting for the month of April.
Well, open interest parity is the difference between central bank rates between two countries that we're looking at. In this case, we're looking at the US and Canada. The US has been hiking rates over the past two years. The Bank of Canada's last move was actually to cut back in 2015. And so as the differential increases in favor of the US dollar, it puts more and more cost to hedge US assets, and this tends to be a headwind for the loonie when rates in the US are higher than in Canada.
Moving to the middle chart, what's the takeaway there?
So real interest rates are taking nominal government bonds, in this case the 10-year, and subtracting real inflation, or CPI. And what we're seeing is that the nominal rates between the two countries have been pretty constant. However, inflation's started to pick up a bit in Canada, putting pressure on the real industry differential. And so back in 2015, this peaked out and actually has been going in favor of the loonie to February of this year. And that's been a real tailwind for the loonie, as we've seen it appreciate for about 10%. Now, it looks like it's starting to level off now and go the other way. This will add a headwind to the loonie over the next 12 months if it continues.
And finally, in Canadian terms of trade, what is that chart telling us?
Terms of trade is a measure where we price the exports and the imports of a particular country, and we look at the differential. As the value or the price of your exports increases, that's a tailwind to your currency. As they decrease, it's a headwind. If you look at commodity prices, they've started to flatten out a bit after rebounding from the lows of last year. And so this former tailwind for the loonie now will likely be a headwind as the price of our exports doesn't move a whole lot.
Thank you very much.