The Loonie Has Flown Too Far Too Fast: Mind Your Eye!

Published by on

The Loonie Has Flown Too Far Too Fast


Global Strategy Note: Week of July 23, 2017

Currencies sometimes seem to defy analysis and take on a life of their own. Intrinsically they should be relatively simple constructs that remove the possibility of arbitrage. That is the principle of price Purchasing Power Parity (PPP). Essentially, a commodity should cost the same the world over once allowing for tax and cost differences and currencies should adjust to make that so. Inside we use these simple principles to determine the “fair value” of an exchange rate.

Our fair value for the Canadian dollar (CAD) is 1.35 versus the US dollar (USD) which means it is currently 8% over valued and due for a correction. Indeed, given the speed of the recent appreciation in the Loonie, the currency is also three standard deviations “overbought” on our momentum analysis (Figure 1) which also suggests an imminent correction. The last time the currency was this far overbought was in 2011 and it had corrected to oversold within six months. The Loonie has flown too far too fast – mind your eye!


Figure 1: CAD 3 standard deviations overbought

Figure 1:


It is tempting to value the CAD using commodity prices, observing the strong correlation between the two. As we show in Figure 2 and 3 below, the stronger the oil (or copper) price, the higher the value of CAD. In both figures we have reversed the scale on the commodity axis. These relationships would seem to suggest that the CAD is about fair value, and to make further gains against the USD, the oil and or copper price would need to rise further. We have long argued that the oil price is likely to end the year at around $50 and therefore would not expect significant further CAD strength on the basis of this analysis. That said, these relationships are rather imprecise and it is difficult to infer an accurate fair value from these charts - we can do much better. 


Figure 2: CAD versus USD and the oil price in USD


Figure 3: CAD versus USD and the copper price in USD

Figure 3:


Using the principle of Price Purchasing Power Parity (PPP) we can estimate a “fair value” for a currency. That is, the price of a commodity or a well specified good should be the same in all countries once allowing for tax and cost differences. For example, in Figure 4 we compare prices of iPads, cars and hand bags in both CAD and USD and calculate the PPP exchange rate that results. In this case, the PPP exchange rate is calculated from a small sample of items, with Louis Vuitton providing the best “fit” in terms of the current exchange rate. 


Figure 4: CAD versus USD and the copper price in USD

Figure 4:


Using a larger and more representative basket of goods will provide a more accurate PPP exchange rate. Essentially that is what we have done in arriving at our fair value estimate of the CAD in Figure 5. Our augmented PPP model uses not just relative prices, but relative interest rates, and productivity differentials too. Indeed we use eight separate factors and estimate them over 42 different exchange rates since 1980 controlling for both time and country. This longitudinal approach yields interesting results, including the fair value of the CAD which we estimate to be 1.35 (8% below where it is currently trading). While that represents an appreciation in fair value since last year, it is in no way consistent with the sharp rise in CAD strength seen over the past few weeks and signals a likely correction.


Figure 5: CAD versus USD and fair value 

Figure 5:


Applying this same approach to other major currencies provides some similarly interesting results. When we apply a Brexit control for Sterling, we find that our estimate of fundamental fair value falls from 1.45 to 1.30 against the USD, roughly where it is trading now (Figure 6). We also estimate that the Euro is about right priced at 1.18 against the USD but the Yen should be trading at 100 versus the USD (Figure 7). While the USD has softened considerably this year, our analysis would suggest that it is not too weak against all currencies – notably the Euro and Sterling. 


Figure 6: Sterling versus USD and fair value

Figure 6:


Figure 7: Yen versus USD and fair value

Figure 7:


Global Strategy Team:

Robert Jukes

Global Strategist
T: 44.207.523.4594


Michael Quach
Senior Research Analyst
T: 44.207.523.4528


Ian LeCroy
Research Analyst
T: 416.867.2643


All information is given as of the date appearing in this document and Canaccord Genuity Wealth Management (CGWM) does not assume any obligation to update it or to advise on further developments related. All this information has been compiled from sources believed to be reliable, but the accuracy and completeness of the information is not guaranteed, nor in providing it do CGWM assume any liability.

All views expressed in this document are provided for informational purposes only and does not constitute an offer or solicitation to buy or sell any securities. The statements expressed herein are not intended to provide tax, legal or financial advice, and under no circumstances should be construed as a solicitation to act as a securities broker or dealer in any jurisdiction. All views are intended for general circulation to clients and do not have any regard to the specific investment objectives, financial situation or general needs of any particular person.

Forward-looking statements and past performance are not guarantees of future results. To the fullest extent permitted by law, neither CGWM nor its affiliates or any other person accepts any liability whatsoever for any direct or consequential loss arising from any use of the information contained in this document. Canaccord Genuity Wealth Management in Canada is a division of Canaccord Genuity Corp. Member – Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. 

*Required fields