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posted on 05 November 2015

Where Is The Canadian Dollars Ultimate Bottom?

by Ari Charney, Investing Daily

Investing Daily Article of the Week

The Federal Reserve has been seemingly on the verge of a rate hike for almost a year now. And it's starting to become reminiscent of that old gag from the Peanuts comic.

Every time the Fed is poised to raise interest rates off the zero bound, something happens in the global economy or the financial markets that causes it to defer the action, not unlike Lucy pulling the football away from Charlie Brown just before he's about to kick it.

In its latest statement, the Fed seems to be implying that it's seriously considering raising interest rates at its next meeting. But given the stealth war against deflation that's occurring around the world, we wouldn't be surprised to see some other disturbing event transpire that would cause it to continue to pause.

Such considerations may seem academic to readers of a newsletter that's focused on Canada. But the influence of the Fed's interest rate policy runs deep, especially for two countries that share a border.

Indeed, one of the best examples in recent memory was the so-called taper tantrum in mid-2013, when the Fed discussed its plans to withdraw extraordinary stimulus, and the mere anticipation of such a move caused currencies and rate-sensitive securities around the world to fall into a deep swoon.

For U.S. investors, these currency fluctuations have a very obvious effect on investment performance. During the global commodities boom, the Canadian dollar's rise above parity with the U.S. dollar gave our portfolios an enormous tailwind. But since the boom has come undone, the lower loonie has been a drag on performance.

At this point, U.S. investors who already own Canadian stocks have probably moved to the acceptance phase of enduring a falling exchange rate.

But for those of you with new money to invest, the lower loonie presents an enticing opportunity to buy solid, dividend-paying companies at a steep discount. However, you might be waiting for the currency to hit its ultimate bottom before making a move.

Right now, the loonie trades near USD 0.76, just above its recent low. Should the Fed finally act, then the Canadian dollar would likely decline further, offering a very attractive entry point.

After all, the Canadian dollar can't be all that far from a bottom. The worst forecast for the currency through 2017 is for it to hit a low around USD 0.71.

But that forecast is an outlier. Consensus projections suggest the currency will bottom around USD 0.74 during the first half of 2016, before beginning a modest rise.

However, human beings have a flair for the dramatic, which is why markets tend to overshoot on the upside, as well as the downside. So if a bottom is in sight, it wouldn't necessarily surprise us to see the loonie hit USD 0.70, at least briefly.

Aside from how well the country's economy navigates the oil shock, the biggest effect on the Canadian dollar will be the extent to which the Bank of Canada's (BoC) monetary policy continues to diverge from that of the Fed.

The central bank's policymakers see a lower exchange rate as crucial for engendering an economic turnaround, one that they hope will be sparked by a surge in export activity courtesy of a lower loonie and a resurgent U.S. economy. And that was on the BoC's wish list even before the energy boom went bust.

The Canadian dollar did have a brief surge recently due to election euphoria over the Liberal victory at the polls. Traders were perhaps eyeing the party's platform that calls for CAD 60 billion in infrastructure spending over the next decade.

But economists project the proposed infrastructure investment will only lift the country's gross domestic product by a tenth of a point to five-tenths of a point per year.

Still, that's not quite as insignificant as it sounds. The consensus forecast is for Canada's economy to grow 2% annually over the next two years. The BoC has previously identified 2.5% growth as the minimum threshold to remove excess capacity from the country's economy. So half-a-point could be pretty meaningful in this context.

Some financial pundits believe this could take pressure off the BoC to provide additional easing. The central bank has cut its benchmark overnight rate twice this year, to 0.5%.

A majority of traders are currently betting that the overnight rate will remain at its current level through the end of 2016. By contrast, the federal funds rate is expected to rise to at least 0.5% by the end of next year.

It's actually pretty rare for the two central banks to be headed in opposite directions. The Fed and the BoC are usually pretty closely aligned in their policymaking. In fact, it's been more than 20 years since they headed in different directions. But as BoC Governor Stephen Poloz has previously observed:

"Those are usually fairly temporary things."

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