The Canadian dollar has taken a hellacious beating in the past fifteen months, falling 10 per cent from a 2012 high of $1.03 (U.S.). How low can it go? Two measures roughly corresponding to market value and fundamental value suggest that the bulk of the damage is behind us.
Global investors view the loonie as a commodity-based, hard asset currency. They often take their trading cues from materials stocks and the Canadian dollar has generally followed the course of the S&P/TSX Materials Index.
Mixed signals from the Bank of Canada have complicated the relationship between commodity stocks and the loonie. The domestic currency rose when while the central bank had a tightening bias because a rise in the bank rate would have been followed by loonie strength – foreign assets would be attracted by higher bond yields. The reversal of policy, with the BoC now neutral, caused further weakness in the currency.
Nonetheless, commodities and resource stocks maintain a major influence on the value of the Canadian dollar, as the first chart shows. Generally speaking, the current value of the loonie is in line with materials stocks. This implies that global traders and investors are unlikely to aggressively sell the loonie from here.
S&P/TSX Materials Index vs CAD/USD
SOURCE: Scott Barlow/Bloomberg
The second chart compares the value of the Canadian dollar to the Citi Commodity Terms of Trade Index for Canada. The Terms of Trade Index is a weighted average of prices for all of the commodities Canada exports.
The loonie is clearly undervalued relative to our country's terms of trade, which strongly suggests that the selling is overdone.
Citi Commodity Terms of Trade Index Canada vs CAD/USD
SOURCE: Scott Barlow/Bloomberg
So, the Canadian dollar appears fairly valued relative to materials stocks, despite intensely negative market sentiment towards resource-based equities. The domestic currency is also deeply undervalued relative to the prices of the commodities the country exports.
Importantly, Canadian manufacturing competitiveness has improved along with the slide in the dollar. The lower levels should help boost exports, particularly from the wallowing economy of Ontario. Higher export levels mean an increase in foreign money inflows, and support for the loonie's value.
The Citi index covers commodity prices only and while resources are a very big piece of the export puzzle, they are not the whole story. Sectors like autos, which are barely present in the S&P/TSX Composite and not at all part of the Citi index, are also major factors. But, at the very least, domestic investors can expect the pace of the loonie's decline to slow in the months ahead.