Overview of Canadian Dollars (CAD)
Canada was a resource-based country, and its early economic development depended on the export of natural resources. Canada is currently the world’s fifth-largest gold producer and the world’s 14th-largest oil producer. However, 75% of citizens work in the service sector, accounting for more than 65% of Canada’s GDP.
The Canadian economy began to grow with a weakening Canadian dollar against the U.S. dollar and a free trade agreement on January 1, 1989. The agreement eliminated tariffs on almost all trade between the United States and Canada. As a result, Canada exports more than 78 per cent of its products to the United States.
In January 1994, the North American Free Trade Agreement (NAFTA), including Mexico, abolished most tariffs between the three North American countries. Due to the close trade partnership between the U.S. and Canada, Canada is very sensitive to the U.S. economic situation. If the U.S. economy is unstable, demand for exports to Canada will decrease. The opposite is the same, so exports to Canada will benefit when the U.S. economy is booming.
Bank of Canada
Determines Monetary Policy
The central bank of Canada is the Bank of Canada (BOC). Monetary policy is determined by the Central Bank of Canada Policy Committee, which consists of one president and six vice presidents. Canada’s central bank holds about eight annual meetings to discuss changes in monetary policy. It also publishes monetary policy reports every quarter.
Canada’s central bank’s goal is to maintain the value of the currency. This means stabilising prices. Inflation targets keep price stability agreed with the Treasury Department. Canada’s central bank believes that high inflation will make the economy difficult. In contrast, low inflation can stabilise prices, which helps achieve sustainable long-term economic growth goals.
The Bank of Canada controls inflation through short-term interest rates. If inflation exceeds the target, Canada’s central bank will implement a tight monetary policy. On the contrary, if inflation falls below the target, Canada’s central bank will ease its monetary policy. Overall, Canada’s central bank has maintained its inflation target very well within the range of 1–3% since 1998.
The Bank of Canada measures currency conditions through the Monetary Conditions Index (MCI). It is calculated by the 90-day commercial bill rate change and the G-10 trade-weighted exchange rate change. Canada’s interest rate-to-exchange weight was set at 3:1 based on historical research and refers to the effect of interest rates and exchange rates on changes in economic conditions.
This means that a 1% short-term interest rate hike has a similar impact as a 3% increase in the trade-weighted exchange rate. Canada’s central bank will adjust bank interest rates to change its monetary policy, which will affect the exchange rate.
If the exchange rate rises to an undesirable level, Canada’s central bank can cut interest rates to limit the rise, and if the exchange rate falls, it can raise interest rates on the contrary. However, it does not adjust interest rates to control the exchange rate but instead uses it as a controlling inflation method. The following are the most common policy measures used by the Canadian central bank to implement monetary policy.
1. Bank interest rate
This is a significant interest rate that the Canadian Central Bank uses to control inflation, the Commercial Bank of Canada. If the interest rate changes, other interest rates, including mortgage rates and preferential rates, will also be adjusted for commercial banks. Therefore, changes in interest rates will affect the overall economy.
2. Open Market Manipulation
Large Value Transfer System(LVTS) is an extensive payment system for implementing monetary policy by the Central Bank of Canada. Commercial banks in Canada are borrowing or lending funds through the LVTS to meet their daily funding balance.
LVTS is a computer platform that handles large-scale transactions between financial institutions. Interest rates applied to these daily money transactions are called overnight rates or bank rates. If these overnight interest rates are higher or lower than market interest rates, Canada’s central bank adjusts its lending rates to commercial banks to change the overnight interest rates.
The Bank of Canada regularly publishes several publications, including semi-annual monetary policy reports that assess the impact of current economic conditions and inflation. Quarterly Canadian central bank reports include financial commentary, feature articles, executive committee comments and important announcements.
Key Characteristics of Canadian Dollars
1. Commodity-Related Currency
Canada is the world’s fifth-largest gold producer and the 14th-largest oil produce, and the correlation between Canadian dollars and commodity prices amounts to about 60%.
Rising commodity prices generally benefit domestic producers and increase income from exports. It is important to note that increasing commodity prices eventually affect import demand from abroad, such as the United States, resulting in a drop in Canadian exports.
2. Strong Connection with the United States.
The United States accounts for around 80 per cent of Canada’s total exports. Canada has recorded a surplus in trade with the United States since the 1980s. Therefore, Canada’s economy is susceptible to changes in the U.S. economy.
The economic growth of the U.S. accelerated trading volume with Canadian companies increases, which benefits the Canadian economy. However, if the U.S. economy slows, the Canadian economy will be shocked as U.S. companies cut back on imports.
Due to the proximity of the United States and Canada, cross-border mergers and acquisitions are widespread as part of an internationalisation strategy pursued by many companies worldwide. This merger and acquisition create a flow of funds between the two countries, ultimately affecting the currency.
4. Interest Rate Difference
Professional Canadian dollar traders closely monitor the difference between central bank interest rates in Canada and short-term interest rates in other developed countries. These differences can be a good indicator of potential cash flows.
This is because it is possible to determine how much the premium of Canadian short-term bonds is higher than vice versa. As investors are always pursuing high-yield assets, the difference in interest rates between the two currencies is an indicator of traders’ potential currency movements. This is very important for Carrey traders who want to enter or liquidate their positions depending on the interest rate gap between global bonds.
5. Carry Trade
Carry Trading is to buy or operate low-interest currency assets by selling or borrowing low-interest currency. When Canadian interest rates are higher than U.S. interest rates, the USD/CAD sell-carry trade increases the widespread carry trade opportunity due to their proximity.
Many foreign investors and hedge funds are looking for opportunities to earn high returns, so Carry Trading is very common. If the U.S. implements austerity measures or Canada begins to cut interest rates, the interest rate gap between the Canadian dollar and the U.S. will narrow. In that situation, the Canadian dollar will be under downward pressure if investors start liquidating the Carry Trade.
Important Economic Indicators in Canada
The unemployment rate is expressed as a percentage of the unemployed population from the total working population.
2. Consumer Price Index
CPI represents the average increase in prices. Suppose economists refer to inflation as an economic problem. In that case, this usually means that general inflation levels, which lead to a decline in economic purchasing power, continue to rise over some time. Inflation usually represents an increase in the CPI of the Consumer Price Index as a percentage.
The Canadian inflation policy, determined by the federal government and Canada’s central bank, is based on maintaining inflation within the target range of 1–3%. If inflation is 10 per cent per year, the purchase value of $100 last year will average $110 this year, and if the same inflation conditions are the case in the coming years, it will cost $121 to purchase.
3. Gross Domestic Product
Canada’s GDP is the sum of all goods and services produced in Canada over a year. This also means income from goods and services produced in Canada. Because GDP represents the gross product, only the final output of goods and services is aggregated except for intermediate goods to avoid duplicate calculations. For example, wheat used to make bread is not included in the GDP tally because it is an intermediate product, but only the final bread is included.
4. Trade Balance
The balance of trade represents the trade history of goods and services in a country. It includes the exchange of products, raw materials, agricultural products, travel, and transportation. The trade balance is a difference between the total amount of goods and services exported by Canada. If Canadian exports exceed imports, it is a trade surplus, and the trade balance represents a plus. If imports exceed exports, they are in the trade deficit, and the trade balance is negative.
5. Producer Price Index
The producer price index PPI is an index group that measures the average change in domestic producers’ selling price. The PPI tracks prices in most production industries in the domestic economy, including agriculture, electronics, natural gas, forestry, fisheries, manufacturing and mining. The foreign exchange market watches how the PPI and PPI indexes of seasonally adjusted final goods have changed monthly, quarterly, semi-annual, and year-on-year.
6. Consumer Spending
It is a national account that measures expenditure by stores and consumption by individual non-profit operators for households. Spending includes purchasing durable goods as well as non-durable goods. However, it does not include individual home purchase expenditure and private entity capital expenditure.