This post was prompted by a post by Stephen Gordon on the Worthwhile Canadian Initiative discussing the Bank of Canada and the exchange rate. I'm not trying to contradict the main point of that post, but rather I just want to add some more information.
The post discusses how the CAD/USD exchange rate is approaching parity, and notes the correlation between commodity prices and the CAD/USD exchange rate. I've reproduced Stephen's chart on this correlation below.
The post discusses how the CAD/USD exchange rate is approaching parity, and notes the correlation between commodity prices and the CAD/USD exchange rate. I've reproduced Stephen's chart on this correlation below.
Clearly CAD/USD is correlated to commodity prices, but I would argue that this correlation is through USD weakness, not CAD strength. Now this seems a little strange; with Canada exporting so many commodities (particularly oil), one would think that an increase in the price of commodities (oil) which increases the total value of exports would lead to strengthening of the Canadian dollar. But if you look closely, the relationship between price of oil and the strength of the Canadian dollar is not consistent. And by the strength of the Canadian dollar I mean the strength independant of the US dollar.
Consider the strength of the Euro. Europe (or at least Euro-land) is a net importer of oil. So an increase in the price of oil should weaken the Euro, just as it should strengthen the Canadian dollar. So the CAD/Euro exchange rate should be correlated to the price of oil, with the Canadian dollar strengthening with respect to the Euro as the price of oil rises.
Below is a Stockcharts chart with 6 instruments as weekly bars for the last 10 years. The top panel has the Dow Jones Commodity Index (brown bars) and the second panel has WTI (crude oil) as OHLC bars with the CAD/Euro exchange rate as a green line. The remaining panels have CAD/USD, Euro/USD and the US Dollar Index.
Now compare WTI versus CAD/Euro. There's a 3 year period from 2005 to late 2007 where it appears that CAD/Euro is correlated to WTI. But from 2002-2005 WTI and CAD/Euro appear to be inversely correlated !?! And from late 2007 till late 2009 is appears that after a period of inverse correlation the two signals lose correlation. On the whole, it doesn't look like CAD/Euro is strongly correlated to WTI over the last 8 years. Similarly, CAD/Euro doesn't look strongly correlated to the DJ Commodity Index either (top panel, brown bars).
Now maybe looking at CAD/Euro isn't the right way to assess the strength of the Canadian dollar independent of the US dollar, but it is a good start. Given that Euro-land is a net importer of oil (and commodities?) while Canada is a net exporter, the lack of correlation between CAD/Euro and WTI (and commodity prices) would suggest that the Canadian dollar is not strongly correlated to the price of oil (or commodities).
However, CAD/USD is correlated to the price of commodities. I would suggest that this correlation is driven by USD -- that is since commodities are priced in US dollars, then a drop in USD will lead to a rise in the price of commodities proportional to the rise in CAD/USD.
Moreover, since the price of commodities is not directly influencing CAD/USD (rather USD is influencing the price of commodities), I'm not sure that the price of commodities adds much extra information when examining CAD/USD. Rather, it might be more informative to look directly at USD, such as the US dollar index -- maybe by comparing USD/CAD to the US dollar index, periods of relative CAD strength would become apparent.
(click to expand)
