The Canadian dollar is down sharply Wednesday in a "risk off" trade following the shocking U.S. election result, but there are reasons to be hopeful for loonie strength in the short term. In the mid-term, however, the potential for anti-trade legislation would be all kinds of terrible for the domestic currency.
Markets don't like surprises and the Donald Trump victory, which certainly qualifies, had overnight global asset markets reacting as they usually do – selling winners, raising cash, and generally reducing exposure to higher-risk investments. Equity markets recovered strongly after the 9:30 open, but the Canadian dollar, viewed as an economically sensitive "risk currency" by global investors, continued to fall.
The copper price was sharply higher Wednesday on hopes for a Trump-driven infrastructure program, and this is the primary reason to be optimistic about the loonie in the short term.
For all the talk of the "petroloonie," foreign exchange strategists at Bank of Montreal believe that copper prices are the largest driver of the Canadian dollar's value. The accompanying chart highlights the consistent positive correlation between copper and the loonie. It is reasonable to expect the dollar to appreciate and match copper's gain once markets stabilize.
Market upheaval and post-election economic uncertainty could cause the Federal Reserve to delay interest rates increases. This would also support the loonie. The yield differential between the U.S. and Canadian two–year bond yield has been the biggest driver of the Canadian dollar's value in recent years in my opinion. A Fed hike in December would create upward pressure on U.S. yields relative to domestic bonds, hurting the Canadian dollar. A Trump-driven delay would likely cause a sharp rally in the loonie.
The U.S. election results make the mid-term outlook for the loonie far less rosy. The president-elect's repeated vow to "tear up NAFTA" threatens future growth for a Canadian economy oriented around access to the world's largest national market.
In a very basic sense, exports determine currency values. When a Canadian company sells goods to a U.S. firm, the U.S. company's bank converts their U.S. dollars into Canadian dollars on foreign exchange markets to complete the transaction. This is the activity that creates bids in currency markets and pushes the market value of the loonie higher.
I strongly suspect that Mr. Trump's efforts to rewrite NAFTA will be focused on Mexico where low wages provide a strong competitive advantage over U.S. businesses. To the extent that the anti-trade initiatives affect the Canadian economy, however, the consequences are potentially dire.
A report issued Wednesday from Export Development Canada estimated that if NAFTA is nullified, and a 10-per-cent tariff was placed on goods entering the United States, domestic GDP could fall by as much as 3.9 per cent. For one, this would mean a major recession. An almost-4-per-cent contraction in the domestic economy would throw GDP growth deeply into negative territory. It also means that the flow of U.S. dollars into Canada would fall sharply, and the loonie's value would fall significantly.
Importantly, this is a worst-case scenario. I don't think it would surprise anyone if, in riding a wave of populist resentment, Mr. Trump was not conscious of the wisdom or feasibility of what he was proposing. No one knows what's really going to happen, and that's a big part of the problem for Canadians and the loonie.