Canadian Dollar is on a Big Mac attack

The Canadian dollar has been on a tear towards par again. The last time that happened was in 2008 when markets hit all time highs. The Canadian dollar almost reached $1.10 in 2007. Are we headed for the same value or is the Canadian dollar overvalued?

From a technical perspective, the Canadian dollar has a lot of strength and momentum supporting it. In the last year, it has risen from 85 cents to a high on Friday morning of 99.35 cents, however finishing the day lower on more worries about the global recovery. The current price has held above the 50 and 100 day moving averages for quite some time now and both relative strength and MACD are positive. Technically, the Canadian dollar is bullish and has been for the last year, despite the odd dip below it’s 50 and 100 day moving averages.

The fundamentals are a much more complex discussion because there are many variables that weigh into this multi-factor model with unknown outcomes. Some of them include global economic recovery, demand for the U.S. dollar, demand for commodities, inflation, interest rates and our fiscal position (which happens to be strong). To give you a sense of how sensitive the Canadian dollar is to some of these variables, we can just look at Friday’s trading pattern. Canada reported stronger than expected retail numbers last week and this gave rise to fears of inflation and, therefore, speculation that the Bank of Canada may raise rates sooner rather than later. In response, the Canadian dollar rose in early trading on Friday. By mid-morning the Canadian dollar had fallen a cent because of more fears of credit problems in Greece, therefore slower global economic recovery, less demand for commodities and a rising U.S. dollar. According to RBC research, some supportive factors include stronger leading indicators of the global economic recovery, commodities trading higher, healthy fiscal situation in Canada, low interest rates, relatively stronger housing and financial sectors, foreign demand and business optimism. The negative factors include pricing for perfection so it is sensitive to weakness in energy prices and the economic recovery, risk of U.S. trade protectionism, trade deficit and over valuation on a PPP basis.

What should the Canadian dollar trade for relative to the U.S. dollar? The 12-month forecast from RBC is $1.12 and from Scotia it is $1.05. Despite this forecast, RBC wrote one of the negatives is that the Canadian dollar is 16.4% overvalued on a PPP basis. According to The Economist “Big Mac Index”, the Canadian dollar is 13% overvalued. In “Exchanging Blows”, March 17, 2010, it was discussed that The Big Mac index is based on the theory of Purchasing Power Parity where exchange rates should equalize the price of a basket of goods across various countries. In this case, they use the price of a Big Mac in the US as the base measure. According to The Economist, the price of a Big Mac in the US is $3.58 and the price of a Big Mac in Canada is $4.06, 13% more, suggesting that the Canadian dollar is that much overvalued. At the extreme, the price of a Big Mac in China is $1.83 suggesting the Yuan is about 50% undervalued and the price of a Big Mac in Norway is $6.87 suggesting that the Crone is 92% overvalued. There is much debate on how reliable the Big Mac Index is but nevertheless it is a measure with a relative base. It does support the argument that despite the problems in the US, the US dollar remains the currency we measure everything against and it is the currency of reserve. Canada will feel the U.S. hunger pains or gorging but for now it appears that the Canadian dollar is having a Big Mac Attack!

This article is written by or on behalf of an outsourced columnist and does not necessarily reflect the views of Castanet.