The surging loonie has aligned with the stock market – and that’s a reason for concern

The Canadian dollar is on a roll, adding to evidence that investors are gaining confidence in a postpandemic economic revival.

Since the depths of the coronavirus-fuelled sell-off in late March, the loonie, now at 73.99 US cents, has gained 5 cents against the U.S. dollar, which qualifies as a big rally in currency terms.

Widely perceived as a “petrocurrency” for its close association with energy prices, the loonie has recently dislodged from crude oil to align itself with the stock market, said George Davis, chief technical strategist in foreign exchange trading at RBC Dominion Securities.

“Equity markets, by a pretty wide margin, have become the most important driver for the Canadian dollar. If you go back to 2007 to 2009, and the credit crisis in the U.S., we saw the exact same development,” Mr. Davis said.

But if, as many market observers fear, the stock market has priced in too much optimism, the Canadian dollar would share that risk by association.

When disaster strikes global financial markets, oil’s influence on the loonie tends to weaken, as markets take cues from broad measures of risk. In “risk-off” mode, the Canadian dollar tends to fall, while a “risk-on” environment benefits cyclical currencies such as Canada’s.

When stock markets began to drop in late February over creeping concerns that the coronavirus outbreak might not be contained to China, before nosediving in March as the pandemic paralyzed the global economy, the Canadian dollar plunged in tandem.

Investor demand shifted toward the usual havens – safe government bonds, the U.S. dollar and gold.

The loonie fell to as low as 68.97 US cents – its lowest level in four years – before rebounding in late March as stock markets stormed back.

Even when crude oil futures turned negative for the first time in history in late April, the loonie was largely unfazed, never closing below 70 US cents.

The S&P/TSX Composite Index is now up by 37 per cent from the low point in March, as economies begin to reopen and investors increasingly bet that the worst of the pandemic is over.

That optimism is also apparent in the behaviour of the U.S. dollar, which has fallen to its lowest level since March 12, as measured against a basket of foreign currencies.

The return of risk-taking in financial markets appears to have reduced investor demand for the greenback and the safety it offers.

The wave of stimulus injected by the U.S. Federal Reserve has also put downward pressure on the U.S. dollar.

“The Fed’s printing press has indeed been busy in the last few weeks … courtesy of assets being purchased at an unprecedented pace,” Stéfane Marion, chief economist and strategist at National Bank Financial, said in a note.

The slump in the greenback has provided a separate boost to the Canadian dollar, which, at roughly 74 US cents, is close to where it was six months ago.

Back then, West Texas Intermediate was trading at nearly US$60 a barrel. Now, WTI is less than US$37 a barrel – further evidence of the loonie’s recent estrangement from the energy market.

That’s not to say the Canadian dollar is immune to energy price movements. Crude may currently be fire-sale cheap by historical standards, but is still immensely improved from the depressed prices seen in April, which has likely added to the loonie’s rise.

Some economists are asking how much more can be expected of oil prices in this environment. “As the reality of depressed equity earnings, and the limitations on the recovery by the potential for a second [coronavirus] wave set in, that would see a stall in oil’s rebound,” Avery Shenfeld, chief economist at Canadian Imperial Bank of Commerce, said in a report.

The strength of the stock market, and by extension, the Canadian dollar, increasingly stand in contrast to the prevailing risks, from geopolitical tensions between the United States and China, to the pandemic’s continuing economic destruction, to U.S. civil unrest.

“A lot of good news is priced in at these levels,” Mr. Davis said.

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