The Canadian dollar (CAD) is the official currency of Canada. Also known as the loonie, after the loon bird on the $1 coin, CAD is the fifth most held reserve currency in the global foreign exchange reserves. As the seventh most traded currency in the world, the value and strength of the CAD has widespread implications for the Canadian and global economies.
A Brief History of the Canadian Dollar
Canada has used some form of the dollar as its currency since 1858. The Canadian dollar was created to align with the dollar used in the United States. Prior to the dollar, Canada relied on the Canadian pound.
In the late 1800s, the Canadian government introduced the gold standard, which pegged the dollar to a fixed quantity of gold. This provided stability but reduced flexibility. Canada abandoned the gold standard in 1914 to free up gold reserves and printing capabilities to help fund its war efforts in WWI.
After WWI, Canada returned to the gold standard briefly, but the system collapsed during the Great Depression. Canada used a floating exchange rate until 1962, when it adopted a fixed exchange rate regime that tied the CAD’s value to the US dollar. This allowed the CAD to trade within 1 percent above or below the USD.
In 1970, Canada introduced a new Canadian dollar that was decoupled from the US dollar. The fixed rate system had created inflation and an overvalued currency. The new floating system gave monetary policy more flexibility. The CAD has been a free-floating currency since it started freely fluctuating in value in 1950.
CAD-USD Exchange Rate
As the two neighboring nations, the United States and Canada have economies that are closely intertwined. Around 75% of Canada’s exports go to the US, while 18% of US exports go to Canada. This means the USD/CAD exchange rate has a significant impact on Canada’s economy and trade competitiveness.
A weaker CAD compared to the USD benefits Canada’s export-driven sectors like manufacturing, oil production, and mining. A stronger CAD makes Canadian industries less competitive abroad but lowers prices of imported goods. The Bank of Canada at times intervenes to influence the strength of the CAD for economic or political reasons.
The CAD and USD generally stay within the range of 1.20 to 1.40 CAD per 1 USD over the long term. The most traded currency pair globally is the EUR/USD, but USD/CAD is within the top 5. Large daily trading volumes between the CAD and USD demonstrate their close relationship.
CAD and Oil Prices
Being a major oil producing nation, Canada’s dollar is closely tied to the price of oil. Around 20% of Canada’s GDP comes from oil and gas extraction and exports. When oil prices rise, it benefits Canada’s petroleum exporting sectors and often leads to a correlated increase in the Canadian dollar.
Higher global oil prices lead to greater demand for Canadian dollars by foreign purchasers of Canadian oil and gas. Rising export revenues in turn boost Canada’s trade balance and GDP growth. However, the inverse relationship is also true. Falling oil prices based on global oversupply or reduced demand negatively impact Canada’s oil sector and the CAD.
Besides the direct impact of oil prices, petroleum exports also represent a major portion of capital flows that affect the CAD’s value against other currencies. Overall, the correlation between oil and the CAD has weakened in recent years as Canada’s economy becomes more diversified, but oil still plays a role in the loonie’s valuation.
Bank of Canada Interest Rates
A country’s central bank and key interest rates have a major influence on the exchange rate of its currency. The Bank of Canada (BoC) uses monetary policy tools like changing its overnight interest rate target to carry out its dual mandates of managing inflation and promoting economic growth.
Lower interest rates tend to have a negative effect on a currency by causing capital outflows to seek higher yields elsewhere. But the impact is based more on the direction of rate changes than the rate itself. For example, if the Bank of Canada raises rates when other central banks keep rates low, it makes CAD assets like bonds more attractive to foreign investors compared to similar USD or EUR assets.
This increased demand for Canadian investments in turn buoys the value of the Canadian dollar. Strategic interest rate adjustments by the BoC taking into account factors like oil, GDP growth, employment, and wage inflation are a key driver of CAD valuations.
Impact of USD Strength or Weakness
Due to the high volume of Canada-US bilateral trade, the overall strength of the US dollar significantly influences the CAD’s value. Around 75% of Canada’s exports go to its southern neighbor, while about 18% of American exports go north.
When the USD is strong compared to other major currencies like the Euro, it benefits Canada’s export competitiveness. However, a weaker USD makes American goods more affordable for Canadians, increasing demand for imports and potentially widening Canada’s trade deficit.
While the Euro, Yen and other currencies affect the CAD, the US dollar’s strength indexes like the US Dollar Index (DXY) tend to be closely correlated to the CAD/USD exchange rate. Overall USD strength buoys the CAD while dollar weakness drags the Canadian dollar down.
Impact of Commodity Prices
Canada has a commodity-driven economy that depends heavily on exports of oil, natural gas, metals, minerals, forestry products, and agricultural goods. Commodity prices in global markets directly impact the export income, GDP, and trade balance of resource-rich nations like Canada.
Higher commodity prices drive up demand for Canadian dollars by foreign importers of Canadian natural resources and commodities. This increased demand applies upward pressure on the CAD. Conversely, falling commodity prices have a negative impact, as Canada earns less foreign currency through fewer natural resource exports.
Besides oil which is the largest single commodity, broader indexes like the Bloomberg Commodity Index that track a basket of globally traded commodities tend to have high correlation with the Canadian dollar’s value relative to the USD, EUR, and other currencies.
Trade Flows and the Balance of Payments
A nation’s balance of payments and trade flows reflect how much demand there is for its currency on the global stage. Canada’s annual balance of trade has flipped between surplus and deficit over the years, but services exports help keep its current account more positive.
When Canada’s trade balance is positive due to high demand for Canadian exports, it leads to more incoming capital that increases demand for the Canadian dollar and pushes the CAD value higher. However, a sizeable trade deficit outflow can devalue the loonie against peers by spurring capital flight out of Canadian assets.
Besides the trade of goods and services, other flows like foreign investment in Canada’s oil sands projects or Canadian investments abroad also impact currency markets. Overall, Canada’s balance of payments driven by trade and investment flows affect the CAD’s attractiveness.
Impact of Inflation Rates
A currency tends to depreciate against its peers when inflation rises rapidly in that country instead of others because inflation reduces purchasing power. Canada has seen some periods of high inflation that contributed to CAD weakness.
While inflation in Canada has been relatively tame in recent decades compared to other major economies, higher consumer prices and wage inflation do erode purchasing power domestically. This dynamic reduces demand for the Canadian dollar over time both within the economy and among foreign exchange traders.
However, inflation rate differences also factor into interest rate changes. If the Bank of Canada hikes rates to counter higher inflation, it can offset the weaker currency impact of inflation and actually boost the CAD — assuming other central banks don’t keep pace.
Credit Ratings and Economic Outlook
A country’s economic health and creditworthiness as reflected in sovereign debt ratings assigned by agencies like Standard & Poor’s and Moody’s influence its currency values. The better Canada’s credit rating and economic growth prospects look compared to other nations, the more appealing CAD assets become.
More positive ratings and upgraded outlooks boost investor confidence in Canada’s economy. This draws more foreign capital into Canadian bonds, equities, and other assets, increasing demand for the currency. A sovereign downgrade or negative economic outlook does the opposite, undermining the CAD.
Factors like political stability, fiscal discipline, trend GDP growth, labor market health, and productivity feed into the perceptions that spur investment flows that can strengthen or weaken the loonie.
Impact of Central Bank Policy Divergence
When major central banks like the Fed and ECB start moving monetary policy in different directions than the Bank of Canada, it alters the relative demand for currencies based on interest rate expectations.
If the BoC maintains low interest rates while the US Fed hikes rates aggressively, it makes CAD less attractive versus USD for carry trades and currency pairs trades, depressing the loonie. Conversely, if BoC tightens while the Fed remains accommodative, it boosts CAD.
Major divergences between BoC’s monetary policy trajectory and its peers brought on by factors like varying inflation rates or economic growth alter the currency market environment and exchange rate valuations.
Impact of Geopolitical Events
Global news events like political changes, wars, pandemics, or natural disasters that impact stability and economic prospects influence currency markets. Certain events may benefit perceived safe havens like USD over the CAD and emerging market currencies.
For instance, wars or crises that disrupt oil markets tend to have an outsized effect on the petrocurrency CAD. Political turmoil in the US could also undermine the USD and boost the loonie as investors turn to Canadian assets as a haven. Exchange rates fluctuate based on global developments and capital flows.
While hard to predict, major geopolitical or environmental catastrophes often spur snap currency movements. Their outcomes determine if safe haven or commodity currencies like CAD become more attractive during tumultuous times.
Forecasting Canadian Dollar Value
The CAD value is challenging to predict reliably due to the complex interplay of commodities, monetary policy, political factors, data releases, and global markets. However, analysts use historical correlations, economic models, and leading indicators to forecast CAD fluctuations.
Factors like oil prices, interest rate differentials, trade balances, GDP growth, and business cycles offer clues into future CAD moves. Combining technical chart analysis with fundamental economic insights allows strategists to make educated guesses on CAD direction.
But unforeseen shock events and policy changes make accurate long-term forecasting difficult. Staying abreast of relevant Canadian and international developments is key to anticipating CAD impacts.
Conclusion
In summary, the Canadian dollar’s valuation versus major currencies depends primarily on commodity prices, monetary policy, data releases, risk appetite for CAD assets, and global economic conditions. USD/CAD is the most watched exchange rate, but CAD trades actively against many peers.
While outlook uncertainty means the CAD is volatile, its performance offers insights into Canada’s economic health and global standing as a commodity powerhouse and advanced economy. Both Canadian and international traders closely track the loonie in the foreign exchange market. Its fluctuations help drive broader financial markets and trade competitiveness.
