Exchange Rate Forecast

Barring extraordinary intervention by the Bank of Canada, I expect the loonie to continue a trajectory towards parity, with a strong possibility of eclipsing that mark in early 2010. The graph above sets out my baseline forecast for the quarterly average US/CAD exchange rate from Q4 09 – Q4 10. The forecast is presented with 50%, 70% and 90% confidence intervals to factor the daily volatility of exchange rates and uncertainty underlying the forecast. The confidence intervals were constructed using spreadsheets from the authors of this (recommended) paper.

The Last Honest Man in Ottawa

Parliamentary Budget Officer Kevin Page calls out Stephen Harper.

"Intervention" is just a fancy word for printing money

This week Mark Carney again, and this time with vigor, threatened central bank intervention should the Canadian dollar continue to appreciate beyond what the Bank considers to be its fundamental value. Carney didn’t specify what level of the US/CAD exchange rate might trigger such intervention, but given the lack of action so far, it would seem that a prolonged move to parity might do the trick.

The Bank’s chief concern is that a high loonie presents a risk that inflation may not return to target in timely fashion. Under normal circumstances, the central bank would simply reduce interest rates to take some air out of the loonie and spur inflation, but of course these are not normal circumstances.

So what exactly is Carney threatening to do? Lets explore the available options.

First, an identity:

M = NFA + (NDA – NW) = NFA + DC

Where M is the domestic money supply
NFA is the central bank’s stock of net foreign assets (gold & foreign currency reserve)
NDA is the central bank’s stock of domestic assets (govt. securities, loans on commercial banks, other)
NW is net worth
DC = (NDA – NW) is the stock of domestic credit made available by the central bank

From the above identity, we see that the monetary base can be increased/decreased by adjusting either the stock of foreign assets or the stock of domestic credit. In a foreign exchange intervention, this can be accomplished one of two ways:

1. Sterilized Intervention – the Bank of Canada buys US dollar assets but offsets the effects on the domestic money supply by selling domestic assets. The effectiveness of sterilized intervention is controversial and many economists believe that it in most circumstances it is ineffective in influencing the exchange rate. If any change is expected to occur, it is through the changing composition of assets (referred to by economists who study such things as the “portfolio balance channel”)

2. Non-sterilized Intervention - the Bank of Canada sells Canadian dollar/buys US dollar assets (increase in NFA) which is not offset by the sale of domestic assets. The increase in NFA increases the domestic money supply (M) and therefore has the same impact as an open market operation.

I think we can take option #1 off the table since sterilization would have no impact on the price level, which is the Bank’s main concern.

If option 2 sounds familiar, that’s because it is essentially quantitative easing, only with an expansion in the money supply coming through an increase in NFA rather than through an increase in domestic credit, DC. Economists tend to believe that non-sterilized intervention is an effective tool for depreciating the currency.

Will the Bank of Canada finally make good on its QE threats? I think that they have talked about it so much that they have no real choice. You can only bluff for so long before you lose credibility. I would guess the trigger would be a run to parity as a result of weakening USD and consequent rise in commodity prices but I guess we will have to wait and see.

How much will the Bank have to increase the money supply to impact the exchange rate? We’ll have to leave that to another post, this one is already too long.

The Training Wheels Economy rolls on

Don’t get me wrong, it’s great that the economy managed to produce 31,000 jobs last month – however, I find it a little hard to shout recovery from the roof-tops when nearly all of the employment gains were from public sector jobs and “self-employment”. Moreover, the fall in the unemployment rate, from 8.7% to 8.4% had just as much to do with the 25,000 people leaving the labour force in September (is this a back to school effect?). The market seemed to agree with my assessment. The TSX welcomed the jobs report by falling 50 points.

All in all, the data released this week continues to point to a modest recovery in Q3 and an economy that would be continuing to slide if not for extraordinary government support.

The recovery is not off to a good start

A few weeks ago Canadian forecasters convinced themselves that growth in the 3rd Quarter was going to be much better than expected. Unfortunately, the data doesn't seem to be cooperating. Retail Sales for July actually fell 0.6%, and real GDP growth in July was flat, with the retail and construction industries posting declines. This may be a concern given that personal consumption expenditures and residential construction tend to be early indicators of recovery - as shown in this chart from Calculated Risk:



We should get a better idea of the shape of the recovery this week with data for Q3 housing starts, building permits, jobs, and the increasingly important BoC Senior Loan offers Survey all being released in the next few days.

My own forecast for Q3 growth is still somewhere around 1-1.5%. Consensus from Bay Street seems to be around 2-2.5%, though I notice that BMO has, again (aside: I think BMO revises every week, it's really something) revised their forecast to 1.3%.

TSX hits my target! Now what?

All the way back in May I made the bold prognostication (read: wild guess) that the TSX should be valued at between 11,400 and 11,500 - up from about 10,200 at the time. I hazarded a guess that the TSX might get to that level by the end of 2009, however it decided not to wait until the end of the year, closing at 11,496 today.

In my previous post I suggested that the market was undervalued and would be pricing in 2009 TSX earnings of about $575 per share. I then applied a long-run average PE multiple of about 20 to arrive at my call of 11,400-11,500.

Current estimates for 2010 corporate profits are in a range of 5-10% growth. My own model of corporate profits is spitting out growth of 30% (which I don't quite believe) - so lets say TSX EPS of around $630-$750. Since so much depends on the multiple applied to these profits, i've made a quick and dirty attempt at incorporating a PE equation based on short and long-term interest rates and nominal GDP growth into my Canadian economy model. The model derived PE suggests an average multiple of between 17-18 over the next year. Applying this multiple to the above range of forward earnings gives a fair value for the TSX of between 11,400 and 13,500, suggesting a market going sideways or a market about to pop by about 20%. A big range to be sure, but perhaps that is consistent with the amount of uncertainty in stock prices.

Could I have arrived at this range by pulling numbers randomly out of a hat? Probably, but what fun would that be?

The Training Wheels Economy

Looking at the most recent National Accounts data from Statistics Canada provides a sense that the Canadian economy can’t quite stay upright on its own. Luckily, the Government and the Bank of Canada have committed to stabilizing the economy until it can, sort of like a set of training wheels on a bike.

For its part, the Bank of Canada has committed to keeping its target rate at an effective lower bound of 25bps until the second quarter of 2010. The fiscal stimulus proposed by the Federal Government is projected by the Bank of Canada to contribute about 2.3% to GDP over the next year and a half, including close to half of the Bank’s projected growth for 2010.

So how long might the economy need training wheels? Well, personal consumption and residential investment seem to have turned, which is normally the case at the end of a recession. However, if this recession is anything like the past, private sector investment in non-residential structures and machinery and equipment may not recover for a while, particularly if bank lending remains tight.





Non-residential investment in structures and M&E contributed an average of about 1% to annual real GDP growth from 2003-2007 before subtracting growth in 2008 and 2009. The fiscal stimulus should go a long way in replacing that growth in 2010, but if consumption growth stalls or the loonie creates a larger than expected drag on exports, we could be looking at keeping the training wheels on for an extended period. If not, a 1980-1982 style double-dip recession is a real possibility.