Dollar parity is only a state of mind

by Levi Folk | September 25, 2007

Canadian economists, politicians and surely currency speculators are cheering the Canadian dollar’s recent rise to parity with the U.S. dollar. The flood of foreign companies buying up Canadian resource firms created a deman for our currency that has sent the loonie soaring—and of course currency speculators have come along for the ride. However, fundamental factors suggest this dance with par will not last long.

It is no secret that the Canadian dollar has been rising on the back of the global commodity boom. To increase output, foreign commodity producers have opted to acquire Canadian companies rather than by searching for commodities below the ground.

The number of cross-border merger and acquisition transactions last year and in the first half of 2007 was at record levels. Two-hundred and seventy eight foreign acquisitions were initiated in the first half of this year alone according to Financial Post Crosbie: Mergers & Acquisitions in Canada . Tellingly, 15 of the top 18 deals had an “international component” to them, and 83% of deal values “involved transactions between Canadian and international parties.”

Billions of dollars in foreign-based transaction translates to billions of dollars of currency demand. Not surprisingly, the Canadian dollar jumped nearly a full U.S. cent the day Rio Tinto Group announced the $38.1-billion dollar acquisition of Alcan in July of this year.

Last year saw the $8.7-billion takeover of Shell Canada by Royal Dutch Shell; the $19.8-billion takeover of Inco by foreign acquirer Companhia Vale does Rio Doce; and the $19.2-billion takeover of Falconbridge by Xstrata PLC.

Fast forward to today and the landscape is considerably changed. The widening in credit spreads since August means highly-leveraged transactions are more expensive and therefore less likely to occur. Issuing high-yield debt is no longer a low-cost proposition since spreads have widened by more than 200 basis points in recent months. Yet equity market prices are breaking new highs, which is hardly a recipe for another record M&A run.

Notice the absence of deals since August when the troubles began.

Jim Leech of Ontario Teachers Pension recently stated on Bloomberg News that the “the debt market has to get its appetite back” before we begin to see any private equity transactions of notable size. If that isn’t an understatement I don’t know what is.

Yet speculators are decidedly bullish on the Canadian dollar judging by the US$13-billion swing in futures contract positions from the start of the year until now, according to data from the Chicago Mercantile Exchange. Sentiment on the Canadian dollar was negative in January based on the roughly US$7.4-billion in short speculative positions.

The problems in the U.S. mortgage market—leading to a 50 basis point easing in the Fed Funds rate—recently has currency speculators singing a new tune. Roughly $8-billlion in short positions have been unwound since January and current stats show non-commercial positions are currently net long.

Yet interest rate differentials offer little indication of where the Canadian dollar may go. The U.S. dollar may be trading on interest rates on a trade-weighted basis, but the Canadian dollar was immune to this trend. Three-month T-bill rates swung in favour of the greenback versus the loonie by 270 basis points from June, 2003, to November, 2005; however, against the Canadian dollar it was down almost 15%.

It is practically a foregone conclusion that the U.S. economy and the economies of Europe will slow over the next year and that should take the heat off oil and other commodity markets. The U.S. housing market continues to deteriorate (having proved one of the best shorting opportunities in recent months). As house prices decline, U.S. consumers may finally capitulate and begin rebuilding their savings, which have been cut to the bone.

Oil markets have been very tight heading into the heating season, but one wonders if that may change. The International Energy Agency (IEA) is expecting OECD demand to rise this year and next, this despite a fall in demand in the U.S. and Europe during a very robust economic backdrop in 2006.

Estimates for OECD oil demand growth are 0.4% in 2007 and 1.6% in 2008. The IEA September Oil Market Report does offer one note of caution: Forecasts are “open to revisions should the fallout of the sub-prime meltdown in the U.S. prove to be more harmful than currently expected.”

Currencies can deviate from fair value for years on end, but recent problems in the global credit markets suggest that developed market economies, commodities, and big ticket M&A deals are set to slow. Therefore, it is only logical that the currency that rode the global commodity boom higher is poised to come down.