It might be the riskiest financial forecast of all: currency. The stakes are a huge. Get it wrong, and your foreign content allocation can implode. Get it right, and you’ll enjoy a multiplier effect on those out-of-county assets.
The Canadian dollar is largely at the whim of forces beyond our control, as commodity demand and the strength of the U.S. economy often trump the wishes of domestic policymakers. These forces conspired to drive the loonie to parity in time for the New Year, but there might not be a lot of momentum left.
In the near term, the Canadian dollar will be worth US$1.01 by the end of the first quarter of 2011, says Fergal Smith, managing market strategist, at the Canadian branch of international research firm Action Economics LLC.
Smith cites the improved global outlook among reasons for the forecast, which would suggest a continued reduction in spare capacity in Canada. That could trigger a rate hike from the Bank of Canada toward the end of the first quarter or the beginning of the second quarter of 2011. By year end, cumulative rate hikes could add up to a full percentage point.
“The market will anticipate this, so that will be supportive of the Canadian dollar,” he explains.
Risk factors to this outlook include a worsening of the sovereign debt crisis in Europe. “That would likely be a drag on the global economic outlook,” Smith says, which would become a negative for the Canadian dollar, since it would simultaneously reduce demand for Canadian commodities and possibly induce a capital flight to safety in the U.S. dollar.
In the medium to slightly longer term, the loonie could range around US$1.04 by the end of the year and around US$1.06 by the end of 2012, according to Camilla Sutton, chief currency strategist at Scotia Capital.
The same factors drive both projections. Sutton explains that the loonie will be driven upwards by continuing global growth, generating increased demand for Canadian commodities, led by China and leading to rising commodity prices. “This will lead to increased interest in Canadian assets,” she says. These assets could include money market paper, bonds, equities and even increased interest in mergers and acquisitions.
Meanwhile, downward pressures on the U.S. dollar will include continuing problems in the American economy and an easing of the European sovereign debt crisis.
Smith and Sutton also project increasing volatility in the relationship between the two currencies. That would mark a departure from the past year, according to Smith, explaining that the European debt crisis and the American economy contributed to a narrow trading range during 2010.
By comparison, volatility will increase in 2011, Sutton says, driven by nervous markets, a fragile recovery and countries devaluing their currencies to drive exports.
If these projections prove at least partially accurate, investors in commodity stocks, resources stocks and mutual funds with strong weightings in Canadian commodity and resources companies should also benefits throughout 2011.