Now looks a good time to buy Canada's 'loonie'
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David Stevenson Apr 26, 2010
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"This year should mark the turning point when private sector demand takes over from the public sector as the primary source of growth," says Bank of Canada governor Mark Carney.
In other words, the economy will be expanding in a healthy way, not because it's being propped up by cheap government money.
This 'proper' growth pick up has one major side-effect. It means that interest rates will soon be rising. But that should boost Canada's currency – also known as the 'loonie' – even more.
Here's how you can cash in...
Why Canada's comeback from recession has been so strong
Canada is making a very quick comeback from the global recession.
For the first quarter of 2010, year-on-year growth is expected to hit 5.8%. That will slow to a more manageable 3.7% for 2010 as a whole, and a forecast 3.1% next year. But when you think that Britain's first-quarter GDP was actually down 0.3% on last year, you realise that Canada is in a different league.
The US is starting to cotton on to Canada's rebound too. David Rosenberg at Gluskin Sheff swears by the US Federal Reserve's "Beige Book" for giving the best clues as to what's going on in the economy.
More on Canada and currencies
• It's time to invest in Canada
• Where to place your bets in the currency markets
And the latest version notes how businesses near the border are doing very well from strong spending by visiting Canadians. It's a bit like Europeans snapping up their shopping in London after the euro's climb against the pound over the last two years. Except that in Canada's case, there are no nasties like Greece or Portugal lurking in the background to ruin the party.
In fact, it's almost the complete opposite. After last month's tough budget, the Canadian budget deficit is set to drop to just over 3% of GDP next year. And as economic growth recovers under its own steam, with the private sector making the running, the government hopes to eradicate the state shortfall completely within five years. It's a far cry from the double-digit deficits that are so fashionable nowadays.
This common sense attitude is just one of the reasons why Canada has been one of our favourite places to invest for a while now. We wrote about this last year: It's time to invest in Canada. And remember, we're talking about a country that's just stashed full of natural resources, which is a great boon for long-term growth.
Your best Canadian bet
So which shares should you buy? Well, there's the rub. The problem is that along with most of the rest of the world, Canada's seen a big rally over the last year or so. And we're very wary about the immediate prospects for global stock markets.
And there's another factor at work here. Although Canada's inflation rate dipped in March to 1.4%, the country's cost of living could soon be rising again. Mr Carney at Canada's central bank says that even core inflation, which strips out the volatile bits such as food and fuel, will stay at around 2% for the foreseeable future.
That, he reckons, is too high for comfort. In other words, the Canadian central bank, which - unlike the US Fed - is prepared to get tough if needs be, is about to return to rate-hiking mode. Although the benchmark overnight lending level has so far been held at its record low 0.25%, Mr Carney has just hinted it could be rising again soon.
That means two things. First, it adds another general caveat about buying shares at the moment, because higher borrowing costs broadly tend to be bad news for stock prices.
But second, it's likely to mean even more good news for Canada's currency (known as the loonie, because there's a picture of the common loon on the reverse of the C$1 coin). That's because the return you'll get for holding it will then improve.
The loonie has been rising as it's a classic 'commodity' currency, i.e. it does well when commodity prices climb. But as the economy improves, a much more long-term upside is on the cards. So simply selling sterling to buy the loonie could still be your best Canadian bet.
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A short-term play on the loonie's move
But what about the shorter view? Some pundits think that the recent move in the Canadian currency means it's done its bit for the moment.
Which is why I reckon this chart is very interesting… (click on the chart for a larger version)
Source: Bloomberg
In the top section, the red line shows the gap (or 'spread') between the yield on Canadian one-year government bonds and their UK gilt equivalents. In other words, it shows how much more a Canadian bond yields than a British one.
This is a bit technical, so please bear with me.
These yields rise and fall in line with the outlook for both growth and inflation in each country. The more growth and inflation there is, the higher the yield will be driven. That's because investors will then demand bigger returns to persuade them to buy bonds rather than to make other investments.
In the last seven years, this gap has ranged between -2.5% and 0.5%. In other words, the best yield gain you could have got from Canadian short-term bonds compared with one-year gilts has been 0.5%.
But look what's just happened. The payout rate on Canadian one-year bonds relative to their gilt equivalent is now hitting new highs. That's because of those higher growth and inflation expectations in Canada.
Now we come to the green line – the sterling/loonie exchange rate.
The lower the green line goes, the higher the loonie has been climbing against sterling. As you can see, the green and the red lines mirror each other pretty well. In other words, as the gap between yields on Canadian and British bonds widens, so the loonie strengthens.
So that new yield high suggests we may well see a further rise in Canada's currency against ours.
As Adam Boyton at Deutsche Bank says, "2010 is the year of the loonie." And judging by history, "when [the loonie] starts to trend, pullbacks are few and far between".
In other words, it may well pay not to wait too long before buying it.
How can you trade sterling/loonie? Probably the easiest way is via spread betting. The usual caveats apply – spread betting is a risky business and you can lose a lot more than you initially stake – so always use a stop loss. But if you fancy giving it a go, the MoneyWeek spread betting comparison site has all the information you need to get started.
Our recommended article for today
Despite the depressed global economy, commodities are enjoying something of a boom. Here, John Stepek and our panel of experts discuss where they would - and would not - place their own money in today's markets.
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David Stevenson
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