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Canadians wanting to know the future course of the loonie should follow domestic materials stocks closely. I don't fully understand why, but the S&P/TSX Materials Index has provided a far better leading indicator of the where the Canadian dollar's exchange rate with the United States is headed than actual trade data.

The first chart this week compares the Canadian dollar price history against the materials index. Not only do the two lines move together, but materials stocks often move first and predict foreign exchange markets. In July 2010, resource stocks rallied well ahead of the currency. In September 2012, a sharp move lower in the materials index signalled prolonged weakness in the loonie.

SOURCE: Scott Barlow/Bloomberg

The laws of economics tell us that the value of trade between Canada and the U.S. should be the primary determinant of currency values. The second chart, however, shows that theory isn't working well in practice.

The Citi Commodity Terms of Trade Index is a measure of prices for the commodities Canada exports, updated daily. For the past twelve months, the index has been moving in a very narrow range, while the Canadian dollar headed sharply south.

More recently, a weak crude oil market has pushed the Terms of Trade Index lower, towards the line on the chart tracking the loonie. If anything, the currency predicted where the terms of trade Index was going.

SOURCE: Scott Barlow/Bloomberg

Resource stocks are highly sensitive to changes in global economic activity – far moreso than the Canadian economy as a whole – and this likely explains why materials stocks have been a better predictor of currency values than trade.

In addition, equity prices also represent the consensus view on the future of corporate profitability, rather than just the current growth environment. In other words, the terms of trade index measures commodity prices today, while equity valuations include an estimate of future operating conditions, which in this case includes commodity prices.

The Canadian dollar is now trading roughly in line with materials stocks and, if recent history provides a precedent, volatility in the exchange rate should decline. Canadians with large U.S. dollar purchases on the horizon should continue to follow the S&P/TSX Materials Index for clues on when to make the transaction.

Follow Scott Barlow on Twitter @SBarlow_ROB.

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