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Foreign traders are loving the loonie, but how long can it run without its legs?

Canadians are always of two minds when our dollar is on a world-beating rally, as it has been all summer. Should we be pleased – or worried?

It's a question that has gained momentum since late July, when the dollar eclipsed 80 cents (U.S.) for the first time in two years. People tend to notice big round numbers like that.

In doing so, the currency also achieved another notable round number: up 10 per cent against its U.S. counterpart since early May.

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That's good news if you're using Canadian dollars to buy things outside our borders. For instance, anyone taking a summer holiday in the United States just won the exchange-rate lottery. (You can toast your windfall with some watery "beer" while you're down there.)

But the speed of the loonie's ascent is cause for nervousness among watchers of Canada's economic recovery, which has surely been aided by a cheap currency. How will the country's 2017 economic growth spurt fare under a considerably stronger dollar? And what if it keeps moving even higher? Could the currency knock the recovery off the rails?

Not easy questions. But to understand the implications of the Canadian dollar's rally, what matters is not just how much the currency has risen, but why.

Back when David Dodge was governor of the Bank of Canada, more than a decade ago, the central bank made a point of distinguishing between two types of Canadian-dollar movements. Type One is a currency appreciation fuelled by growing demand for Canadian goods and services. Type Two involves price movements driven by the financial markets, where shifts in preference and speculative runs on currencies can take place quite apart from underlying economic fundamentals.

Type One is the kind the economy can generally take in stride. Type Two is more problematic, as it can diverge from and even undermine economic conditions.

Without the underlying strength in demand to support the currency gains, a stronger dollar can slam the brakes on export growth, a critical element of Canada's recovery.

So which is the case today? Well, it looks like a bit of both are in play.

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Undeniably, Canada's improved economic fundamentals have justified currency appreciation. The economy has been growing at an average annualized pace of about 3.5 per cent over the past four quarters, assuming the second-quarter estimates are reasonably accurate. It's poised to be the fastest-growing economy in the G7 this year. Export volumes in May (the latest month available) were up 8 per cent from a year earlier; on a value basis, they were up 19 per cent.

On the other hand, the loonie has been surging in the absence of what has long been its key driver: the price of oil. Crude has generally drifted sideways during the Canadian dollar's rally and is down significantly from early in the year. The fact the dollar has divorced itself from oil and other commodity prices is a strong hint that the usual fundamentals are not totally responsible for this currency rally.

Instead, the upturn in the Canadian dollar can be pinned to the shift in the Bank of Canada's stand on interest rates. The central bank's signals in the late spring that it was headed for a rate hike, followed in July by the first increase of its key rate in seven years, swung the pendulum of forex-market sentiment toward the loonie. The central bank is expected to raise rates further over the next year.

Meanwhile, a shift away from a couple of the forex market's big boys – the U.S. dollar and the British pound – are adding to the rush into the Canadian dollar. That might continue. In both the United States and Britain, a deterioration of the economic landscape has cooled expectations for rate hikes over the next few months, prompting currency traders to head for the exits.

Remember that in currency trading, every trade involves two currencies – since you must use money to buy money. When there is a sell-off in one currency, the funds necessarily flow to another, competing currency – and Canada has become an attractive alternative.

It's certainly arguable that the broad strength in the economy can bear an 80-cent dollar in the longer run. But problems would arise if this currency rally is only beginning. The thing about Type Two currency surges is that their length and size, unbound as they are by underlying fundamentals, are unpredictable and often illogical. Some observers have begun to muse about the possibility of a return to parity with the U.S. dollar – with a straight face, no less, though they see it as unlikely. (It hasn't been at parity since 2013.)

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At some point, the market will wake up to a couple of important realities that should cool traders' ardour for Canada's currency.

For one, the Bank of Canada is far from the only central bank on the path to tighter monetary policy. The U.S. Federal Reserve is, at most, on a temporary time out before resuming its rate hikes either late this year or early next. The Bank of England, despite the uncertainty of Brexit and last week's downgrade of its economic forecasts, is still talking about a possible rate hike next year. The European Central Bank has been dropping hints that it may soon begin to reduce its quantitative easing program, a precursor to eventual rate hikes. If forex traders want to chase interest rates, many central banks other than Canada's will be jangling shiny objects in their direction.

Second, without the support of higher prices for oil and other key Canadian export commodities, the loonie is running without its legs. An oil price of a tepid $50 a barrel, where it stands now, will neither generate the flow of export dollars nor attract the scale of foreign investment to put the Canadian currency into a higher orbit. The shifting sands of interest rates may have captured the forex market's imagination for now, but eventually the well-established link between commodity prices and the Canadian dollar will be too strong to resist.

Rob Carrick has a summer project for you saver's out there - challenge your reliance on big banks for the best interests rates and research some alternatives. The Globe and Mail
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