The Significance of the Surprising Canadian Dollar

The Canadian dollar has lost around 0.5% today and that is with the small modest recovery seen across the board since European markets closed for day.   Although my notes in recent days have highlighted the risk of near-term Canadian dollar losses, its weakness today will have many people scratching their heads.  

Consider that two large foreign direct investment deals were announced that is worth almost 1% of Canada's GDP.  The most important transaction is a $15.1 bln acquisition of Nexen by China's Cnooc.  It is a cash transaction and represented a little more than a 60% premium over July 20 closing prices.  This deal represents the largest foreign acquisition by a Chinese company.

Separately, Sinopec announced it was taking acquiring a 49% stake in the UK unit of Talisman Energy for $1.5 bln.  Reports indicate that Talisman has assets valued at around $2.5 bln this year.  Talisman shares as well as Nexen's are up sharply today, though the Toronto Stock Exchange is off about 1.5% at pixel time, which is roughly the same magnitude of loss as the S&P 500 is experiencing.  

Counter-intuitively, the Canadian dollar fell to its lowest level against the US dollar in more than two weeks today.  The acquisition news is important from a sector or company point of view.  However, in the foreign exchange market it is overshadowed by more important developments.  

Investors and speculators need to have some sense (hypothesis) of what drives a currency.  There are numerous reasons why even a large cash direct investment would have minimal impact.  The amount is not all done on the announcement.  The acquirer may have already purchases calls on the currency to manage contingent risk.  The acquirer need not buy the currency; it could borrow it locally.  

To appreciate what is driving the Canadian dollar two forces stand out.  The first is the general risk environment, for which we use the S&P 500 as a proxy.  Over the past 60-days, the return of the Canadian dollar and the return on the S&P 500 (percentage change) enjoys a 0.87 correlation.  The record, at least going back to 1993, is near 0.90, so the Canadian dollar and the S&P 500 are near record correlations.  

The second is the Canadian dollar's correlation with oil.  If the S&P 500 is a proxy for risk, maybe the price of oil is a proxy for growth and not simply an important Canadian export (and import).  More work needs to be done to test that hypothesis, but at any rates, at 0.79 today it is the highest it has been since the Bloomberg time series began in 2006.  For a brief period of time in early 2011, the Canadian dollar was inversely correlated with oil.  The correlations do move around quite a bit in the horizon of many participants, which is why we often look at them.  

These two considerations, the general risk environment and  perhaps the growth outlook may continue to override other considerations.  Canada is expected to report tomorrow a recovery in May retail sales after a 0.5% decline in April.  The risk to the consensus view seems to be on the downside, and although it is the only important Canadian data of the week, it may not be very influential for the Canadian dollar.  

Support for the US dollar is seen near CAD1.0150.  The trend line drawn off the late June and then mid-July high comes in today near CAD1.0175.  The US dollar had earlier tested our objective initial objective near CAD1.02.  A move above there could could spur another 0.5-1.0% gain.