The constant stream of loonie-focused analysis in the media obscures the fact that, over the long term, the value of the domestic currency is completely straightforward. Determining the Canadian dollar's short-term path, on the other hand, is a lot trickier, but recent data suggests it's currently undervalued. Or, that commodity prices are set to fall significantly. It's complicated.
The first chart below shows that over the long term, the value of the loonie in U.S. dollars is determined by Canada's terms of trade – the net Canadian dollar value of goods that cross the border in both directions.
GNI, GDI Terms of Trade Index - Canada vs CAD/USD
SOURCE: Scott Barlow/Bloomberg
When a Canadian company increases exports to the U.S., for example, the American company receiving the goods sells U.S. dollars and buys Canadian dollars to make payment. This drives the exchange rate higher. The reverse case – declining exports – causes the opposite reaction in the exchange rate.
Statistics Canada releases terms of trade data quarterly, and with significant delays, so it's backwards-looking and not much immediate use to investors.
The Citigroup commodity terms of trade index for Canada, which is priced daily, provides a partial solution to this dilemma. It does not reflect manufactured goods, but the volatile nature of commodity prices, and the sheer scale of Canada's over two million barrels per day of energy exports to the U.S., is historically the biggest factor in determining terms of trade.
The second chart implies that the loonie is currently undervalued, by a significant amount, relative to current commodity prices. It is unequivocally a positive indicator for the Canadian dollar.
Citi commodity terms of trade index - Canada vs CAD/USD
SOURCE: Scott Barlow/Bloomberg
The chart may not be so positive for commodity prices, however, notably oil. At the moment, the loonie is clearly priced for lower resource prices. And, since energy exports account for more than double that of metals and almost four times forestry exports, it's safe to assume that crude prices are at the heart of the disconnect.
The loonie is priced for weaker North American energy prices and so is the futures market. The futures curve for West Texas Intermediate (WTI) crude prices implies a $90 oil next year and $85 for early 2017.
Prominent hedge funds are also betting on lower oil prices. At the recent Sohn Investment Conference, a gathering of hedge fund heavyweights, PointState Capital's Zach Schreiber Capital, disclosed that WTI prices going "a lot lower" is his top investment idea for the remainder of the year.
Investors should reduce holdings in the energy sector. Mr. Schreiber could be wrong – he wouldn't be the first hedge-fund manager to make a bad trade – but the combination of the currency rates and the WTI futures curve suggests that investors should stop worrying about the loonie and start thinking about protecting themselves from a drop in crude prices.
Follow Scott Barlow on Twitter @SBarlow_ROB.