So far in 2005, the Canadian dollar is down and the American greenback is up.
However, there is little agreement on whether this trend will continue.
Analysts’ forecasts for the loonie this year are all over the map, ranging from 75-90 cents US.
At least for now, the two-year erosion in the U.S. currency’s value has stopped.
Last week, the Federal Reserve Board, the U.S. central bank, raised its benchmark interest rate by one quarter of a percentage point to 2.5 percent. That makes Canadian and American rates equal for the first time since 2001. Canada’s higher rates for the previous several years attracted investment in Canadian bonds, which supported the loonie’s value. Expectations are that the U.S. economy will heat up and the Federal Reserve, also called the Fed, will continue to raise U.S. rates to prevent inflation. Analysts think the Bank of Canada will keep its rates steady, on the premise that the economy is already held back by the stronger Canadian dollar.
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This interest rate spread would make the Canadian dollar less attractive than the greenback.
However, interest rates tell only part of the story.
The impetus of the U.S. dollar’s decline against almost all world currencies was its rising budgetary deficit and current account deficit. The former relates to government spending while the latter refers to the fact that the United States imports far more than it exports.
As the U.S. dollar drops, it should make American exports more attractive and start to address the current account deficit, but most analysts doubt there will be much impact until 2006.
However, Fed chief Alan Greenspan played down the twin deficits on Feb. 4 and said the weaker dollar and tougher budget discipline in Congress might start to offset the factors that have pressured the currency. Indeed, on Feb. 7 U.S. president George Bush presented his budget plan, which limits increases in federal spending to 3.5 percent. While spending more on the military and security, it would cut spending on agriculture, the environment and housing. This is projected to cut the annual federal deficit to $390 billion in 2006 from $427 million in 2005.
However, Greenspan also warned that because globalization has increased the amount of economic interaction between countries to an unprecedented level, there is little relevant historical precedent to guide forecasts.
The Canada-U.S. exchange rate is also influenced by other currencies. For example, the U.S. and the rest of the Group of Seven leading developed countries are pressuring China to let its currency float. The yuan is now fixed at 8.28 to the U.S. dollar. Critics say this means the yuan is undervalued by about 40 percent, making Chinese products appear cheaper than they should be on international markets and helping the Asian giant’s booming economy.
China would help the U.S. dollar if it floated the yuan, but the Chinese government shows no sign of moving quickly on this.
Another factor in currency is commodity prices, especially oil.
Because the U.S. is a net importer of oil, the higher its price the larger the outflow of dollars and the larger the current account deficit.
Higher oil prices support the Canadian dollar because this country is a net exporter of oil.
But for now it seems oil will not challenge last fall’s peak of about $55 per barrel.
Oil inventory in the U.S. has risen and the peak of the winter heating demand is over. However, oil prices are not expected to fall a lot. The Organization of Petroleum Exporting Countries has indicated it would cut production to stop the price falling lower than the low $40s.
Of course, there is always the possibility of oil production surprises, with so much coming from volatile regions such as the Middle East, Nigeria, Russia and Venezuela.
Barring such disruption or other shock such as a major terrorist attack, it appears that the American dollar, and by extension the Canadian dollar, might have found stability in 2005.
