When the chips are down, you sure find out who your friends are, don't you?
The Canadian dollar can add the Bank of Canada to its growing list of fair-weather friends, after the central bank dropped its interest rate axe for the second time in two weeks yesterday – and made it abundantly clear that more cuts are still to come. The bank's downright depressing outlook for the Canadian economy – including sharp cuts to its inflation and growth forecasts – sent currency traders swooning. The dollar lost 1.38 cents (U.S.) to close at 82.39 cents against its U.S. counterpart, its lowest level in more than three years.
On the surface, the exodus looked curious; after all, the Bank of Canada's 25-basis-point rate cut yesterday was actually smaller than the 50-per-cent cut an increasing number of top economists had anticipated. (A basis point is one-hundredth of a percentage point.) Interest rate differentials among currencies are a key driver in foreign-exchange trading, so higher-than-expected rates would generally be a positive for a currency.
“When they're selling on bullish news, this tells you this [currency] is going lower,” said Richard Briggs, a forex broker at MF Global Canada in Montreal.
But the Bank of Canada accompanied the cut with a definitive shift in its rate bias. In its statement accompanying the rate decision, the bank said “some further monetary stimulus will likely be required” – crystal clear, at least in central bank-speak, for “we're not done cutting yet.” And that's after slicing its key overnight rate target in half, to 2.25 per cent, since last December.
Suddenly, what many experts believed would be a solid bottom for the overnight rate – 2 per cent, a level the central bank has never breached since it began its current rate-setting regime in 1996 – looks set to fall. Canada could soon be paying its lowest interest rates in decades to buyers of our currency.
It was less than a year ago – Nov. 7, 2007 – that the loonie soared as high as $1.10, supported by multiple pillars of strength. Canada's economy was strong, and prices for oil and other Canadian-exported commodities were booming. Canada boasted strong fiscal and trade surpluses. The U.S. dollar was in the midst of a long-term slide that showed no signs of ending soon. At a time when the U.S. Federal Reserve Board was slashing interest rates, the Bank of Canada was holding steady.
In the past year, those pillars have crumbled one by one. The Bank of Canada is now projecting economic growth of a meagre 0.6 per cent for both 2008 and 2009. Commodities have tumbled; oil prices are less than half their peak levels of last July. Canada's trade surplus is shrinking fast, and private-sector economists are warning that the federal government is on course for a budget deficit next year, for the first time since 1996. The global credit crisis has triggered a flight to the safety of tried-and-true U.S. government bonds and T-bills, turning around the U.S. dollar at the expense of most other major currencies.
Little surprise, then, that the loonie was in descent even before the Bank of Canada announced an emergency rate cut two weeks ago. But with the central bank now having cut its key overnight rate target by 75 basis points in two weeks, with more to come, the currency's last support has buckled.
With few reasons left to stay in the Canadian dollar, hedge funds that had been piling into the Canadian dollar on its upswing have been aggressively cashing out – something they remain eager to do as long as credit woes continue to hold them captive. And that's another weight around the loonie's neck for the foreseeable future.
“It's being sold by big players; it's just a lot of divestment,” said Mr. Briggs of MF Global. “[Canada] was the place to invest. Now, it's all slowing down.”
Still, there are some bright lights in all this gloom.
For one thing, among major central banks, only the U.S. Fed has been more aggressive at cutting rates over the past year than the Bank of Canada. That could mean that when most of the world's other leading economies are still grappling with interest rate reductions, Canada will be set to turn back upward, which should lend some support to the currency in 2009.
Secondly, these lower rates bode well for the Canadian stock market.
Stocks historically perform their best in low-rate environments, essentially because the returns they offer look more favourable to investors relative to the returns offered from government bonds. It's worth noting that the dividend yield alone on the S&P/TSX composite index – 3.8 per cent – is not only far above the Bank of Canada's rate benchmark, but even outstrips returns on a 10-year Canadian government bond. At some point, that's got to cause investors to gravitate back to the stock market.
Finally, though this might offer little comfort, many experts believe that the rate cuts have now gone so deep that they simply have to end soon – if for no other reason than they are already headed toward record lows.
“There's not a lot more to give,” said Jack Spitz, head of forex trading at National Bank Financial.