THE CANADIAN DOLLAR IS OVERVALUED

The TD Economics department put out an interesting research piece on the value of the Canadian dollar arguing that the loonie is slightly overvalued.

The research piece argues that, although there are strong macroeconomic reasons for the rise in the Canadian dollar, three forecasting models tested argue that the level hit by the loonie in the fourth quarter of 07 – when it reached $1.10 to the US dollar – is not sustainable. Their three models give the loonie a value of $0.93 - $0.95 US.

Below are graphs displaying the actual value of the loonie and the value implied by their three models (a Purchasing Power Parity approach, a Behavioural Equilibrum Exchange Rate model, and the Bank of Canada model). Note that all these models show the dollar to be above the forecasted (i.e. explainable) level. They also have a great graph showing the correlation between commodity prices and the Canadian dollar.

GO CANADIAN DOLLAR - Think twice before buying US equities.

As I write this the Canadian dollar is trading at $1.07 to the US greenback and most Canadian finance articles I'm reading are suggesting you should jump into US equities - these are cheap by historical standards and the Canadian dollar is bound to retreat. This blog's opinion is that no one knows were the loonie is headed next. Consequently, you should save yourself a lot of stress by insuring your portfolio against currency movements.

First, let's discuss some factors contributing to the loonie's strength and the dollar's weakness.

• The US has a current account deficit of roughly $760 Billion (USD) (or -5.6% of GDP) and a budget deficit of approximately $200 Billion (or -1.5% of GPD). The current account deficit points to weakness in the greenback as it reflects that Americans are buying more than they are selling to the rest of the world. As they must sell dollars to pay for these imports, this deficit should put downward pressure on the US dollar.
  


• In contrast, Canada is the only G7 country with a twin surplus: our current account surplus sits at $22 Billion (USD) ( or 1.8% of GDP) and our budget surplus is at $12 Billion (or 0.6% of GDP).


• Furthermore, commodities comprise 35% of Canada's exports and our proven oil reserves stand second only to Saudi Arabia's. As long as China and India continue to grow and demandthe type of goods we export, the underlying strength in the loonie is bound to continue.

In short, as long as the US continues to spend more than it earns and China/India's growth continues to put upward pressure on commodities, the underlying strength of the loonie should persist.

Now let's discuss how you can protect your portfolio against further currency movements: buy funds tracking foreign indices that are hedged to Canadian dollars. Every bank has one, I believe. RBC has this one, for example, that tracks the S&P 500. I use XSP in my portfolio.

I'll finish this post with the main reason why you should use foreign funds that are hedged to Canadian dollars: sleep. These funds save you a lot of worry with regards to currency movements. If you expect to retire in Canada, why add currency risk to your portfolio?