Loonie hits parity. Now what?

Posted on: April 8, 2010 in: Uncategorized with 0 comments

The Loonie has hit parity to the US dollar. Long live the mighty Loonie! Now what? In the short term, I can see how momentum will keep pushing the Loonie towards the 1.10 US per CAD level we saw back in November 2007. But beyond that?

Currency movements are notoriously difficult to predict, otherwise all the forecasters would be sipping daiquiris on the beach and that would not be a pretty sight. However, one indicator, Purchasing Power Parity (PPP) offers some guidance.

PPP is the idea that the same product should cost about the same in different markets. Cars for example, as the Globe & Mail’s Jeremy Cato writes here.

Or McDonald’s burgers, as in The Economist’s Big Mac Index. The 20 year old Index has had some hits and misses over the years. But generally, it does a decent job of forecasting long term currency movements, especially compared to the professional forecasters.

Right now, the Index says the Loonie is overvalued by 15% to the US Dollar. If it climbs to 1.10 USD, that would leave it 26% overvalued.

Now, just because a currency is overvalued doesn’t mean it immediately falls. In fact, as the chart below shows, currencies can spend years trading far away from their parity value (ie. 1.00 on the Chart). However currencies do tend to head toward their fair value over time, say three to five years.

Intuitively, that makes sense: an over-valued currency hurts economic competitiveness. Think over-priced European goods and labour. Just as an under-valued currency helps competitiveness. Think China and the on-going row over its currency policy.

For our Loonie, while the view is nice from up here, eventually we’ll need to eat and all the fish are underwater.

If you’re thinking of investing in US assets such as equities or bonds using ETFs, currency is a factor, as this table explains:



The chart below shows the Purchasing Price Parity value relative to the US Dollar of the Euro, the CAD and the Australian Dollar (another developed, commodity-heavy currency), with the heavy line at 1.00 marking fair value. As the chart shows, currencies tend to move toward fair value over the long term but often overshoot. Extreme valuations tend to be short-lived.

Both the CAD and the AUD rallied beginning in 2001 as commodity prices hit new highs. Both currencies fell sharply when the commodity bubble burst in 2008 and only recently began a fresh rally, along with commodity prices.

The Euro has had a volatile history. Prior to 1999, I calculated the Euro as three parts German Deutschemark and one part French Franc. (Remember those? We may yet see them return.)

Click on the chart for a larger image.


Thanks for reading.
As always, your comments are welcome.
Until next time,
Regards,
Vikash
8 April 2010

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