What’s next for rates and the dollar?
Expect gradually higher rates in 2005, and a Canadian dollar getting comfortable at 80 cents U.S., if not higher.
For a preview of key elements of the Canadian economy in 2005, look back to the fourth quarter of 2004. On two occasions in the fall of 2004, the Bank of Canada raised interest rates. Throughout most of final quarter, the Canadian dollar traded in the neighbourhood of 80 cents U.S.
According to John Anania, Assistant Chief Economist of RBC Financial Group®, the rate-hiking cycle is expected to continue. Consider it the slow unwinding of the Bank’s previously accommo-dating monetary policy.
"I’d describe it as getting rid of an excessively stimulative environment for interest rates," says Anania. "There’s been a lot of excess baggage the past few years, mostly in terms of U.S. growth. This has allowed the Bank of Canada to be patient about raising rates.
"Now, we’re very close to the point in the business cycle where we’ve absorbed excess capacity, and rates will rise."
The Bank of Canada’s target band for inflation is 1% to 3%, with a preference to land right in the middle, if possible. Core inflation is now running close to 2%, which provides further encouragement to nudge rates higher.
RBC Financial Group forecasts a bank rate of 3.5% through most of 2005, ending the year at 4.0%.
CANADIAN DOLLAR HOLDING THE ACES
The Canadian dollar has come a long way over the past two or three years, when it commonly traded at the mid-60-cent level per U.S. dollar. The dollar has seen significant appreciation since then. In Anania’s view, this is mostly due to factors outside Canada’s influence.
"It’s really a reflection of the weakness of the U.S. dollar against all major currencies, not just Canada’s, because of the vast U.S. trade deficit," he says. This imbalance in the U.S economy is likely to persist for some time, providing ongoing support for the Canadian dollar. However, with China’s economy expected to slow, commodity prices will only increase moderately in 2005, removing one pillar of support behind the dollar’s rise.
"On balance," says Anania, "we feel the Canadian dollar will be well supported in 2005." He looks for the Canadian dollar to end 2004 at around 80 cents U.S., and to spend most of 2005 trading in this range.
Another issue to watch is oil prices. With crude oil trading at more than $50 U.S. per barrel – including a geopolitical risk premium Anania estimates at $10 to $15 per barrel – the impact on Canada’s economy will likely be neutral. Not so for the U.S., which is dependent on oil imports to fuel its economy.
HOW C$ RISE IMPACTS AGRICULTURE
For an industry as export-oriented as Canadian agriculture, the rise of the Canadian dollar is a serious issue.
Why? Because agricultural exporters selling U.S. dollar-denominated commodities (wheat, canola, beef, pork and more) are at a distinct disadvantage. As the dollar rises, export sales denominated in U.S. currency return fewer Canadian dollars to Canadian producers and processors. Also impacted are Canadians trading in commodities in which the U.S. competes on the world market.
Brian Oleson explains the impact of a 10% rise in the Canadian dollar. "Look at gross revenues for Canada’s crops, it’s around $15 billion," says Oleson, Professor of Agricultural Economics at the University of Manitoba. "A move by the dollar from 75 cents up to 82 cents translates into a $1.5 billion drop in crop receipts alone."
In Oleson’s analysis, the prospect of an 80-cent dollar could very well be a best-case scenario for the near term. The gorilla in the china shop is the U.S. federal government deficit. It’s currently projected at around $500 billion. Meanwhile, the Government of Canada’s books are squarely in the black.
"There’s no current resolution or plan to deal with the U.S. deficit issue," says Oleson. "I don’t see any alternative other than a continued and perhaps rapid weakening of the U.S. dollar. We need to deal with the fact that 80 cents is probably rock bottom. It could be 90 cents before long."
Of course, the impact of the higher C$ bends both ways. Over time, Oleson explains, a large portion of the loss on the revenue side comes back in terms of lower costs. This reflects the lower cost in Canadian dollars of U.S.-made and U.S.-dollar-influenced products like farm equipment and farm chemicals.
Whether the Canadian dollar trades at 80, 85 or 90 cents, Canada’s international competitiveness will be impacted. At what point does a strong Canadian dollar cause fundamental damage? Oleson says there’s no magic number.
"Commodity prices vary so much from year to year, it’s very difficult to isolate the impact of gradual movements in the exchange rate from year to year," he says. "But you have to think: based on a 65-cent dollar, it was easy for us to be competitive with the U.S. When we no longer have that advantage, will we still be competitive?"
Oleson believes we will, for two reasons. First, Canadian farmers are innovative and determined. Second, despite current weaknesses, agricultural prices will be much stronger over the longer term.
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