Loonie falls after Bank of Canada warning

OTTAWA — The Bank of Canada got what it asked for Wednesday as the Canadian dollar tumbled more than a cent following a clear warning that a persistently strong loonie could derail the recovery.

OTTAWA — The Bank of Canada got what it asked for Wednesday as the Canadian dollar tumbled more than a cent following a clear warning that a persistently strong loonie could derail the recovery.

But analysts say a careful reading of the trading action suggests the two events share at best a tenuous connection. Regardless of what the central bank says or does, the Canadian currency is likely headed for parity with the U.S. greenback once again, they say.

Deputy governor Timothy Lane’s warning the bank is prepared to revert to quantitative easing to rein in a persistently strong dollar had an immediate effect on trading Tuesday afternoon, said currency analyst David Watt of RBC Capital Markets.

The dollar weakened after the remarks were posted on the Bank of Canada website, closing down 0.75 cents for the day.

The loonie continued its descent Wednesday, closing at 91.09 cents US, down 1.01 cents.

But Watt doubted Wednesday’s decline could be credited to Lane’s remarks, noting that the U.S. dollar was up against most other major currencies, and that oil was trading lower — two factors working against the loonie.

“There’s no doubt the clarity of the statement yesterday got the market’s attention,” he said.

“But in this case, the Canadian dollar was already pretty pricey relative to the economic outlook, so the market itself was probably looking for a trigger to sell off the loonie.”

Most economists believe the longer term trend is for the loonie to track higher toward parity as early as the end of this year, regardless what the central bank says or does.

The reason is that as the global economy recovers, demand will build for commodities that Canada has in abundance, particularly oil. Hot commodities were the main drivers behind the loonie’s record ascent to $1.10 US in the fall of 2007.

A secondary factor is that the loonie is a beneficiary of extensive quantitative easing measures introduced by central banks in Europe and the United States, which has had the effect of increasing the money supply and weakening those currencies.

Bank of Montreal economist Douglas Porter traces the loonie’s recent surge from about 77 cents US in early March to the U.S. Federal Reserve’s use of the extraordinary monetary tool this spring in an effort to shore up credit markets.

”Essentially quantitative easing is just printing more of your currency without having anything to back it up, and the Bank of Canada is one of the few central banks that hasn’t gone that route,” he explained.

At least not yet.

Lane’s warning is that the Bank of Canada is prepared to invoke the quantitative easing option if the loonie doesn’t fall in line with what the bank believes should be its value.

The question is whether the bank has any better claim than the markets to pegging the “correct value” of the loonie vis-a-vis the greenback, or any other currency.

Derek Holt, vice-president of economics with Scotiabank, says the central bank hasn’t proven in the past that it does, nor that it can be effective when it has chosen to intervene in currency markets.

”They stopped doing intervention in 1998 because of a very weak track record. They couldn’t sustainably influence what the market thought the value should be beyond a flash in the pan market reaction,” he said.

Holt even takes issue with the conventional view that a strong dollar is bad news for the Canadian economy because it prices exports out of world markets.

There’s a degree of truth to that assertion, he says, but adds that the costs are exaggerated. Many businesses take insurance against currency fluctuations. As well, he says a strong dollar brings benefits in the form of cheaper consumer items and business capital goods, about three quarters of which are imported.

”It’s nowhere near the negative it is portrayed to be,” he said.

Part of the reason past interventions were largely ineffective is that the efforts were aimed at supporting the currency, which entailed the sale of foreign reserves, which are not inexhaustible. If the object is to weaken the currency, however, the bank does have the ability to flood the market with Canadian dollars, theoretically an unlimited supply.

But there is no free lunch, Holt cautioned. He said the end result of a weaker currency could be higher borrowing costs, thereby damaging the economy you intended to protect.

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