Japan's vast earthquake and unfolding nuclear catastrophe will likely drive Canada's currency below its U.S. equivalent in the near term, as investors dump assets tied most closely to global growth.
The worsening crisis has chopped the price of oil, metals and other commodities Canada exports. It means the Bank of Canada will probably keep interest rates on hold for longer, removing one key attraction of the higher-yielding currency.
Currency strategists and traders said the Canadian dollar is also vulnerable because a lot of players had held long positions before the disaster in Japan, hoping for further gains. Many must now sell to lock in profits or avoid losses.
"If the downward pressure were to continue I can see it potentially retesting the high around Jan 31 ... a little bit over parity," said Mark McCormick, a currency strategist at Brown Brothers Harriman in New York.
"Outside of the risk aversion story, it also comes down to positioning ... a lot of investors have essentially positioned themselves long on commodity currencies, so it looks like there's a lot of unwinding pressure from a short squeeze."
Analysts pointed to Commodity Futures Trading Commission data last week that showed currency speculators had boosted bets the Canadian dollar would appreciate.
Canada's currency fell more than 2 1/2 cents (U.S.) Tuesday from Monday's close to touch $0.9974 to the U.S. dollar, or $1.0026, its weakest point since Feb. 11.
That mirrored a plunge in commodity prices, which sent the benchmark Thomson Reuters-Jefferies CRB index down nearly 3 per cent.
Analysts said there is a real risk the currency will soon retest its 2011 low of $1.0060, or 99.40 cents (U.S.).
"It is not a reflection of confidence in Canada or any fundamentals. This is being driven by sentiment, by technical factors, and by events overseas," said Michael Woolfolk, senior currency strategist at BNY Mellon in New York.
Mr. Woolfolk saw a 75 per cent chance that the Canadian dollar will fall below the U.S. dollar within the next week.
This would mark a stunning pullback for the Canadian dollar, which hit a three-year high just last week.
The currency has traded above the one-for-one level with the greenback since the start of February. On March 9 it rose as high as $0.9667, its strongest level since November 2007.
The Canadian dollar had appreciated partly on the prospect that rising commodity prices would improve Canada's economic outlook, and prompt the Bank of Canada to resume the rate-hike campaign that it halted last year.
Higher interest rates and resulting increases in bond yields tend to strengthen a country's currency by attracting capital. Canada's rate-sensitive two-year bond yields 1.57 per cent, well above the 0.56 per cent yield of its U.S. counterpart.
The Canadian dollar's short-term direction will hinge on whether the situation in Japan and "whether markets continue to price out rate hikes," said Jeremy Stretch, head of foreign exchange strategy at CIBC in London.
"If that's the case, then those currencies which have been geared towards risk, commodity growth on global growth, and/or rate expectations are all probably going to suffer."
Still, Mr. Stretch saw good support for the Canadian dollar around $0.9985 to $0.9990 to the U.S. dollar.
By 11:30 a.m. (1530 GMT) Tuesday the Canadian dollar had recovered to around $0.9842.
Firas Askari, head of foreign exchange trading at BMO Nesbitt Burns, said there had been some interest from longer-term players such as reserve managers at central banks in buying the weakened Canadian dollar.
Analysts said the near-term outlook was shaky, but many long-term reasons to buy the currency remained intact. These include Canada's relatively strong fiscal situation, a healthy banking system and abundance of natural resources.
Some Canadian firms may benefit from reconstruction activity in Japan. Shares of several forest-products companies have spiked since the earthquake.
BNY Mellon's Mr. Woolfolk forecast that as the crisis passes, the Canadian dollar will resume its rise to hit $0.94, or $1.0638 (U.S.), by the end of 2011.
"Although there's a good chance we could see parity briefly over the next week or two, that is not where it's going to end up at the end of the year," he said.
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