Lower loonie and looming election will lead to volatility in economy

Expect more volatility as federal election looms that’s too close to call

The dramatic drop in the Canadian dollar over the past two years has had significant implications for businesses, consumers and investors.

The currency has declined nearly 25 per cent since the winter of 2013, when it last flirted with parity. That’s the biggest two-year drop on record.

The big question now is how long we’ll have to live with a lower currency given the weakness in the Canadian economy. Three fundamental factors have hit the Canadian dollar, BMO Capital Markets Economics says.

The most obvious is a pullback in commodity prices linked to the cooling economy in China and other emerging markets. Declining demand has had a significant impact on oil prices, which are down 50 per cent, while a basket of non-energy commodities is also down 17 per cent since 2013.

The second factor is the sustained strength of the U.S. dollar. The loonie has declined much more against the U.S. dollar than against other currencies, such as the euro, the British pound and the Japanese yen.

Finally, there’s been a notable shift in monetary policy since Stephen Poloz became the Bank of Canada governor. He reversed the bank’s previous bias toward tightening, talked up the importance of exports and cut rates twice, while appearing to welcome a lower exchange rate.

“Canada has quickly gone from being the first major central bank to tighten in the recovery to possibly the last to ease,” BMO notes.

What lies ahead is more volatility as the country moves into a federal election race that’s too close to call. Also on the horizon is a possible rate increase by the U.S. Federal Reserve and more potential bad news about Canadian economic performance, which has been negative for five consecutive months and is flirting with recession.

The currency dropped below US76 cents this week and could be in for another swoon before strengthening to 78 cents next year as oil recovers some ground, BMO’s forecast says.

In the meantime, the dollar’s dive cuts both ways for businesses. Yes, it makes their exports more competitive in the U.S. market, but it also drives up their costs for imported inputs like machinery, equipment and other goods.

Also, to the extent that Canada has lost a share of its manufacturing base to the U.S., Mexico and offshore locations, the leverage it gets from a lower dollar is diminished.

What hasn’t helped either is that the U.S. manufacturing sector took a long time to rebound, and so demand for Canadian goods and services took some time to pick up. We’re just now seeing signs that exports have begun to grow.

On the home front, the dollar’s impact is significant. Major importers such as retailers feel the pinch from the higher cost of imported goods, while consumers get hit by higher prices as inflation inches up.

In fact, history shows that consumer spending in Canada is closely tied to the currency’s movements. When the dollar strengthened in the period from 2002-08, real consumer-spending growth averaged 3.8 per cent a year, BMO calculates. By contrast, during the loonie’s decline in the decade between 1992 and 2002, consumer spending rose at an annual rate of just 2.4 per cent.

At least one group of Canadians has fared well from a lower dollar; those investors who have ventured beyond the country’s borders, especially into the U.S. stock market. The return on U.S. stocks in Canadian dollars has been massive, reflecting the surge in major U.S. indexes, as well as the strengthening greenback.

The performance is all the more impressive given that Canadian stocks have been flat over the last four or five years and down significantly this year because of the oil slump.

Looking ahead, it’s hard to make a case that the Canadian currency will appreciate much over the next year or two. Canada needs a lift from exports and related capital spending in order to replace the boost it once got from housing and debt-financed consumption, economists at CIBC World Markets note.

A weaker loonie could be around for a while, even if energy prices rebound, they say.