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David Rosenberg is the founder of Rosenberg Research and the author of the daily economic report Breakfast with Dave. Krishen Rangasamy is the senior global economist with the firm.

We have uncovered some underlying strength in the Canadian dollar that is being masked by the broadly based strength in the greenback – part and parcel of this recent “flight to safety” across all asset classes.

The loonie has actually held up very well across a basket of non-U.S. dollar currencies. The fact that Canada is endowed with natural resources that are in even shorter supply in the aftermath of the war in Ukraine will show through more forcefully once the overcrowded long U.S. dollar trade unwinds, as it surely will at some point. Not to mention the fact that Canada is pursuing a far more expansionary fiscal policy and tighter monetary policy, which should mean a stronger Canadian dollar, both in theory and in practice.

This is a currency where the dip should be bought. In fact, our models point to a move toward $1.20 for the USD/CAD exchange rate – or 83 US cents per Canadian dollar – based on current commodity prices and interest rate differentials. The “undervaluation” gap is wide and will close before long. Forex traders beware.

The loonie has yet to benefit from the epic 245-per-cent surge in the Bank of Canada’s commodity price index since the end of April, 2020 – the highest 24-month jump in recorded history – and the associated positive terms-of-trade shock. In fact, what is completely bizarre is how the commodity price index has soared 50 per cent in the past year and yet the nominal “Canadian Effective Exchange Rate Index” (CEER) – the Bank of Canada measure that is a weighted average of bilateral exchange rates against currencies of Canada’s major trading partners – has weakened. This breakdown between the Canadian dollar and commodities is likely not going to prove to be anything more than a temporary phenomenon.

Some will point to some unfavourable regulatory developments in Canada’s oil and gas sector to argue for a permanent change in the relationship between the Canadian dollar and commodities. To be sure, stricter environmental regulations stemming from the federal government’s net-zero pledges have curbed investor enthusiasm in the natural resources sector. Capital expenditures in mining, quarrying, and oil and gas extraction have shrunk over the years to just $44-billion last year, less than half what they were back in 2014.

But even with that constraint, natural resources continue to be a crucial cog in Canada’s growth machine and a critical underpinning for the country’s balance of payments. Indeed, resources now account for almost 60 per cent of merchandise exports – a record – and global supply shortages are going to keep demand for Canadian energy, metals and foodstuffs on an accelerating path. This is not priced into the Canadian dollar at the current $1.30 level.

So why the divergence between the loonie and commodities? A closer look at the Canadian dollar’s path over the past year reveals an interesting bifurcation. The CEER, while down slightly over the past year, fully reflects the bull market in the greenback. But the currency is up almost 3 per cent year over year against the basket of currencies other than the U.S. dollar. Since April last year, the Canadian dollar has appreciated against most major currencies, including the euro and the British pound, as well as other commodity currencies – up almost 5 per cent against the Australian dollar and South African rand, more than 6 per cent against the New Zealand dollar and more than 9 per cent against the Norwegian krone. So as we have been saying with the price of gold priced in non-U.S. dollars, the Canadian dollar is actually in a stealth bull market.

Clearly, this bifurcation of Canadian dollar exchange rates is not about trade flows. Not only did Canada register a third quarterly goods trade surplus in a row (and four surpluses in the past five quarters), but the surplus with the U.S. hit an all-time high of $33.5-billion in the first quarter of 2022, contrasting sharply with the record deficit with non-U.S. trade partners. The external trade and payments fundamentals are solid; it is just the fast money in the futures and options markets fleeing to greenbacks in this latest period of uber-angst in the risk-on trade that has undermined the Canadian dollar and prevented the positives from being fully reflected “in the price.” Note that the trade-weighted U.S. dollar’s ascendency started last summer, just as market volatility began to rise.

And one cannot blame monetary policy divergence between the Federal Reserve and the Bank of Canada for the loonie’s weakness versus the greenback because those central banks are both tightening aggressively. If anything, the Bank of Canada is more aggressive than the Fed, which on paper should have prompted a Canadian dollar appreciation versus the U.S. dollar, not a depreciation. Note that the Overnight Index Swap market is pricing end-of-year central bank rates at 2.9 per cent in Canada (versus 2.8 per cent in the U.S.). Market expectations for a more aggressive BoC are also reflected in the three-month Treasury yield spread with the U.S., which jumped last month.

The bottom line here is that generalized U.S. dollar strength amid heightened global investor risk aversion is the most plausible explanation for the Canadian dollar’s weakness in the face of soaring commodities and an outperforming equity market.

So where will the loonie end up once this bout of risk aversion fades (as they all do, eventually)? To answer that question, we computed an equilibrium exchange rate by modelling the Canadian dollar as a function of its two main drivers – namely, the commodity price index and Canada-U.S. interest rate differentials. Based on those fundamentals, the Canadian dollar is currently undervalued relative to the U.S. dollar. More specifically we find that the USD/CAD should be around $1.20, not the $1.30 of today.

Read more from David Rosenberg:

Here’s why this is not the time to be jumping back into the stock market

David Rosenberg’s Strategizer: Where to put your money (and where not to)

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