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STEPHEN GORDON

The paradox of parity Add to ...

Many analysts are expecting oil prices to continue to rise in the medium term and for the Canadian dollar to continue to appreciate above parity with the U.S. dollar as oil prices rise. But if the past is any guide, what we may see instead is an exchange rate that stays near parity, even as the prices of oil and other commodities continue to rise.



In the past decade, we have seen two episodes of sustained increases in oil prices. The first began in 2002 and ended with the financial crisis of 2008, and the current one began in January, 2009. In both cases, the Canadian dollar rose with oil prices in a fairly straight line, increasing by about 1 U.S. cent for each $2 (U.S.) increase in oil prices. (See also here for a more detailed history.)



But this relationship only seems to hold up until the point where oil prices reach $85 and the Canadian dollar reaches parity with the US dollar; see the graph below. For some reason, the stable linear relationship between the oil price and the Canadian exchange rate broke down at parity. Instead of appreciating to $1.30 as oil prices approached $150 in 2008, the dollar fluctuated in a narrow interval just under $1.



The same pattern appears to be repeating itself in 2011. As oil prices increased during 2009-10, the Canadian dollar appreciated on the same path it had taken in 2002-07. And when oil prices reached $85 and the dollar reached parity, the relationship broke down again.



I don’t know what to make of this. The only plausible explanation I can come up with is that while foreign exchange traders may trust their models when they predict exchange rates that are less than $1, they are less confident about trading in ranges above parity. In the absence of a model they trust, traders appear to be viewing parity as a focal point; a number that everyone looks at, simply because they think everyone else is looking at it.

















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