Over the past year, the Canadian dollar (CAD) has been gradually appreciating in value, rising by 15 percent after it fell to a low of 0.69 USD in March 2020. What’s driving the loonie’s flight?
Oil prices, which briefly turned negative in April 2020, were one reason why the loonie struggled. The CAD is largely impacted by the price of oil since Canada earns a large portion of its U.S. dollars (USD) from the sale of oil. As oil prices have rebounded to pre-pandemic levels, this has helped to strengthen the CAD.
At the same time, the USD has been losing its luster. Significant U.S. stimulus actions have increased the money supply, creating concerns about future inflation, and placing downward pressure on the greenback. With near-zero interest rates and a yield on U.S. government bonds closer to that of other developed nations, this may reduce demand for U.S. Treasuries and further weaken the USD.
Will the loonie continue its upward flight? Here is some “food for thought.” The “Big Mac Index,” published by The Economist magazine, is a fun tool to make exchange rate theory digestible. It compares the purchasing-power parity (PPP) of global currencies. PPP suggests that over the long run, exchange rates should adjust so that an identical basket of goods/services costs the same in each country. Instead of using a basket of goods, it creates an exchange rate by comparing the cost of a Big Mac in a nation’s currency to its cost in the U.S. Comparing this to the prevailing exchange rate determines whether a currency is considered under- or over-valued. The bar chart shows the under/over valuation of the CAD versus the USD based on the Big Mac. The actual exchange rate is shown on the blue line.
Currency fluctuations are a normal part of the financial markets. While a stronger CAD may provide better buying opportunities to purchase U.S. assets, for longer-term investors the impact of currency changes on returns has the tendency to even out over time.
Big Mac Index Over/Under Valuation: CAD vs. USD 2011 to 2021 (Jan.)
Blue Line: actual exchange rate
Bar Chart: The bar chart shows the under/over valuation of the CAD versus the USD based on the Big Mac.
Source: January data: github.com/TheEconomist/big-mac-data, accessed 2/11/21. (Graph created by PWM with data from The Economist)