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If the Canadian dollar's return to parity with its U.S. neighbour is being viewed with considerably less alarm this time around, the general consensus is it's because the current run is much more supported by fundamentals - and much less by speculation - than the 2007 rally was.

In many respects, that's absolutely true. Yet the currency has gotten way ahead of one of its vital pillars of fundamental support: Commodity prices.

Overshot by a dime? The Canadian dollar has traded in very high correlation with prices for Canadian commodity exports - the two have moved almost in lockstep for most of the past decade. But over the past year, while both the currency and commodity prices have rallied strongly, the dollar's gains have substantially outpaced prices in Canadian-produced commodities.

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"Despite $85-plus [U.S. a barrel]oil, the Canadian dollar is still at least a dime ahead of the level suggested by commodity prices," UBS Securities Canada Inc. strategists George Vasic and Garry Cooper wrote in a report this week.

"When the Canadian dollar last hovered around parity in [the first half of 2008] the oil price averaged $111, and commodity prices over all were about 30 per cent higher."



The crude component
Of course, there are other fundamental factors underpinning the Canadian dollar's direction beyond the price of the country's commodity exports. Expectations of early interest rate increases from the Bank of Canada, Canada's comparatively strong economic outlook, and the country's relatively stable and low-risk fiscal and financial conditions are all feeding into the currency, and can explain away the gap that has emerged between the dollar and the commodity market.

Still, as Bank of Montreal senior economist Earl Sweet points out, the price of oil has become an increasingly influential component in the Canadian currency as it has risen in recent years. That's because energy exports have assumed a much bigger share of Canada's trade balance - playing a larger role in the terms of trade that ultimately define the relative value of the currency in the global marketplace, especially for such an export-dependent economy as Canada's.

In a report released yesterday, Mr. Sweet showed that as Canada's trade balance in manufactured goods has slumped over the past decade and net trade in non-energy resources has held steady, energy exports have ballooned - and now stand as the overwhelmingly dominant contributor to Canada's exports.

"Oil is becoming an increasingly important factor for the economy and the currency," Mr. Sweet said. He forecast that expected strong demand for oil "will help support the loonie at, or moderately above, current levels for the next few years."

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