The rebound over the last year in the Canadian dollar has left the Bank of Canada in a bit of a quandary. The strong Canadian dollar has proven to be a challenge for Canadian exports as it has made Canadian goods and services more expensive. This leaves the policy makers at the Bank of Canada between the proverbial “rock and a hard place”.

If it decides to raise interest rates aggressively and the US Federal Reserve decides that it can afford to wait to raise interest rates in the US it is likely that the Canadian dollar could be in for a prolonged period of appreciation. The implication for Canadian exports is clearly negative.

The central bank knows that it has to be mindful of preventing inflationary pressures from taking root. On the other hand, Canadian interest rates can only go so far ahead of US interest rates. If the spread between the two countries’ interest rates widens too far in Canada’s favour, then the Canadian economy could be hit with the sledge hammer combination of high interest rates, a surging Canadian dollar and by extension a slumping export sector. Not to mention the fact that many consider the Canadian housing market to be overheated – which is yet another concern for Canadian monetary policy makers.

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One other variable that Canada would have to consider is that as the Canadian dollar has become increasingly popular amongst investors around the world, foreign inflows of capital are likely to stay strong – again putting upward pressure on the “loonie”.

As exports tend to slow down with a strong Canadian dollar, imports and spending by Canadians abroad is rising. The number of Canadians doing their shopping in the US has been steady and rising as they take their newfound purchasing power to get bargains on lower priced US goods. For Canadian retailers, this has to be an area of concern. We can also look to the Paper and Forest sector to be severely impacted by the dollar’s strength.

With imports starting to rise, Canada is going to need a stronger uptick in US imports. Otherwise, the net-exports segment of Canadian GDP could begin to put a damper on the strength of Canada’s economic rebound.

Clearly, the Bank of Canada has its work cut out. It is going to have to balance the need for interest rate hikes against the movements of the Canadian dollar. At this point in time, the market seems to have priced in at least one interest rate hike and now maybe two – back into its calculations.

AJ Sull, CFA, MBA, CMT is president and chief investment officer at Pacifica Partners - Capital Management in Surrey, B.C.

1 Comment

by Deltahedge Mar 06 2010 9:17 AM

This is a very good analytical piece. However it does conclude with an erroneous premise namely: that Canada is going to need a stronger uptick in US imports. The fundamental problem for Canada is that the US is in tatters and cannot overcome their problems. The US economy is 70% consumer driven and it all boils down to one thing: disposable income. Without private sector job growth, home equity growth and debt reduction there cannot be a recovery in the United States. Forty out of fifty States are technically bankrupt with California and Illinois in the lead. Debt deleveraging can only occur two ways: 1) default or 2) devalue the debt through inflation by debasing the relative value of the US Dollar. Most probably, The FED will print to prevent default. But in either case, the Can$ will only get stronger versus the USD. Consequently, Canada must find new growing economies such as China and India to sell its natural resources where the strength of the Cando is less of an issue. Ontario’s manufacturers must also reinvent themselves to move away from a highly concentrated auto sector which US consumers can no longer afford.