The Canadian dollar has been bouncing around parity with the US dollar recently, and the Fed's adoption of another round of quantitative easing plus the relaxing of the Chinese government's tightening policies has people (including me) thinking that USD-denominated commodity prices will rise, and with it the Canadian dollar.
But will it? The last time we were in this situation, something odd happened when the CAD-USD exchange rate hit 1.0.
(Yes, I know that there are other things affecting the exchange rate other than oil prices. One of the things this graph tells me is that for the present purposes, they don't matter nearly as much as does oil.)
As best as I can make out, the story goes like this. During the 2000's, oil prices drifted up and dragged the CAD with it along what looks to be a fairly straight line. By the time oil prices hit $US 80 in September 2007, the CAD was near parity with the USD. Oil prices continued to rise, and it looks as though the relationship that had held for six years remained stable for a couple of months more: the Canadian dollar continued to appreciate.
But here's where it gets weird. For some reason, the CAD depreciated back down to about USD 1.0 in November 2007, and it fluctuated around parity for the next eight months or so, even though oil prices almost doubled. The explanation for this doesn't seem to be interest rate differentials; Mike Moffatt's small forecasting model breaks down here as well.
After that, the financial crisis hit, and everything reverted back to where we were in the mid-2000's. Since then, oil prices and the Canadian exchange rate have been moving back up the same path they traced out earlier, and we are now roughly where we were back in September 2007.
What happens next? As I mentioned earlier, I'm expecting USD-denominated oil prices to continue increasing, but the linear relationship could break down again at the same point it did last time, for at least two reasons:
- A story based on psychology and that fact that 1.0 is an important focal point. (Someone will no doubt be able to articulate this much better than I can)
- The Bank of Canada would prefer to avoid a sharp appreciation, and might adopt a more expansionary policy as the Fed embarks on QE2.
Or not. It's not as though anyone has a great track record in predicting oil prices and exchange rates.