Even though there are no ways of knowing for sure, there are ways of knowing for pretty sure.
– Lemony Snicket (in A Series of Unfortunate Events)
As we near the end of 2020, our thoughts turn towards 2021 and our economic and market outlook for what the year may hold. Over the next couple of weeks, my team and I will be sitting down, combing through our hundreds of charts, data sets, and models to formulate our 12-month outlook and asset allocation.
The markets never stop. In truth, our work doesn’t stop with a calendar year outlook either. Most of our financial models are updated on a monthly or even daily basis, where data permits. Therefore, our 12-month outlook is constantly evolving as we roll forward. Our currency view is a great example of this, as our fair-value model is updated with daily data.
So, as a prelude to our more comprehensive year-ahead outlook (and because we’ve had a number of questions regarding our view towards the Canadian dollar lately), below we highlight our view on the current and future value of the Canadian dollar for the next 12 months.
We‘ve been receiving many questions recently with regards to our view of the Canadian dollar (CAD) and our outlook going into 2021, as the direction of the CAD will have an impact on foreign-denominated securities. We continue to forecast an appreciation of the CAD relative to the U.S. dollar (USD). We are near our earlier forecast of US$0.77 and believe the CAD can see further appreciation towards US$0.79 with risk to the upside over the next 12 months (or CAN$1.30‒CAN$1.265). We believe investors should expect this trend of an appreciating loonie to continue, as we forecast an overall weaker period for the U.S. dollar and stronger oil prices over the near-term with an upside target of US$50/bbl.
We continue to believe in the three tenets of our loonie call that we highlighted earlier this fall.
We believe the U.S. dollar will continue to depreciate.
The U.S. Dollar Index (DXY) has fallen as much as 10% since March, owing to the significant monetary inflation by the U.S. Federal Reserve. In truth, the United States isn’t the only country to boost its money supply through fiscal or monetary policy. But the degree to which the U.S. has expanded the money supply overshadows the other major centres of Europe, Japan, or Canada.
Typically, the money supply of any country should grow commensurate to nominal GDP growth. At times, however, it can be expanded or contracted based on monetary or fiscal policy. If each country’s money supply expanded at the same pace, then currencies would be less likely to fluctuate against each other. But when one country expands its monetary base faster than others, a devaluation should occur. In today’s case, the U.S. has expanded its money supply (as measured by M2) at a far greater pace than other countries. As such, we’ve seen the U.S. dollar depreciate. We believe increased fiscal deficits, the Fed’s bond buying, and the trade deficit are likely to lead to continued downward pressure on the greenback.
Oil prices tend to be negatively correlated to the U.S. dollar and, therefore, will continue to trend higher.
The majority of commodities are priced in U.S. dollars. As the value of the U.S. dollar falls, commodity prices tend to increase. From a statistical perspective, the R-squared of oil to the DXY is 0.81 over the last 10 years; the R-squared of the CRB Spot Commodity Index to the DXY is 0.82. (Think of R-squared as the degree of sameness between two variables. In this case, the movement in the U.S. dollar would explain approximately 80% of the movement of the Commodity Index over time.) Given our view towards the U.S. dollar falling in value and, additionally, that as economies start to open up, oil demand will return, we believe the price per barrel of crude is likely to trend higher, with our upper range being US$50/bbl over the next 6‒12 months.
The Canadian dollar remains a petro-currency.
Our work continues to show that the Canadian dollar remains much more sensitive to oil prices than to other factors. While the three-month daily correlation between the price of oil and the CADUSD had weakened in the early fall, it’s climbing again (current correlation of 0.43). Looking at it another way, our fair-value model for the loonie to oil prices has averaged a deviation of US$0.0001 since the end of July. Based on our work, it’s difficult to argue against the influence of oil prices on the Canadian dollar.
Over the past number of years, the Canadian dollar’s correlation to the interest rate spread between Canada and the United States has also been a contributing factor to its movement. However, over the past couple of months, it would appear as though this relationship — the Canadian dollar and the two-year spread — has broken down. As such, if investors want a confident view on the direction of the loonie vis-à-vis the U.S. dollar, we suggest paying particular attention to the price of oil. That would include not only supply and demand fundamentals and speculative positions in futures, but also the direction of the U.S. dollar and its underlying factors. In short, broad U.S. dollar depreciation will lead to oil price gains, and along with it, Canadian dollar appreciation against USD.
Overall, we reiterate our view towards CADUSD appreciation. With the loonie likely to reach US$0.77 in very short order, as oil prices continue to trend higher, we believe we can see US$0.79 over the course of the next 6‒12 months, with risk to the upside. Given the current low-yield environment, one in which we believe longer-term interest rates can trend higher over the next year, our CADUSD view is of most importance to fixed-income investors. There’s little room to spare for currency headwinds when the U.S. 10-year Treasury yield has gained 0.25% in the last three months. Therefore, we continue to emphasize hedged strategies for Canadian fixed-income investors to protect their yield.
Philip Petursson, CIM
Chief Investment Strategist and Head of Capital Markets Research
A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.
Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.
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