Canadian Dollar Driver: Commodities or Interest Rates?

The Canadian dollar made new highs for the year a week ago and has been consolidating since. Yesterday's US dollar bounce carried it through the first technical corrective target near CAD1.1780 initially, but then fell through the pre-weekend lows to record an outside down day and there has been follow through today. Look for a near-term retest on last week's lows near CAD1.1477.

We note as well that the net speculative position at the IMM had been short since last July, but has reversed and has been long since earlier this month, but with 5449 net long contracts, positioning is still not very extensive. We would also note that the Canadian stock market, closed yesterday for Victoria Day, is the best performer in the G7 this year, gaining 11.8%, including today's early gains. The next best G7 equity market is Japan's Nikkei up 4.86% after today's advance.

What is driving the Canadian dollar ? Many if not most observers seem to be attributing its gains to the general investment climate where there is a greater appetite for risk and rising commodity prices. The macro environment is difficult to refute, as incremental improvement has been seen--especially in second derivatives (the pace of contraction slowed), the volatility of the equity markets (including VIX), and credit spreads, like the TED spread and LIBOR-OIS.

The rise in commodities seems partly tied to the macro picture, including buying hard assets (or claims on hard assets) for fear of paper assets, and partly a function of Chinese demand (including for stockpiling).

Correlations between the Canadian dollar and two chief commodities, oil and copper, have increased. Again, we perform the correlations on percent changes.

We included the Canadian dollar's correlation with the Australian dollar to get to another complication to the understanding of the driver of the Canadian dollar. The correlation between the two currencies appear more stable than between the Canadian dollar and oil and copper. Most of the stories about the Canadian dollar focus on the commodity angle. They account for about 56% of Canada's exports, which are themselves a little more than a third of GDP. However, the focus on commodities tends to keep one's focus on trade flows and yet we know, especially for a major industrialized country, capital flows tend to swamp trade flows.

The discussion of what is driving the Canadian dollar then would be enhanced by some consideration capital flows. As one such proxy, we took a look at the old BED spread. This is Canadian BA futures compared with US Eurodollar futures. The Canadian dollar's rally has coincided with a dramatic interest rate development. Looking at the Dec 09 contracts, the spread was near 89 bp on April 21 as the US dollar bounced above CAD1.24. However, the spread, which is the premium the US offers over Canada has fallen in half and stands near 42.5 bp today. Looking further out, we looked at the Dec 00 contracts. In late April, the US offered 71 bp more than Canada. Today about 10 bp.

The disincentive for holding Canadian dollars has been reduced as commodities rallied and Canadian stocks outperformed.