US Dollar Canadian Dollar Exchange Rate Forecast

Finding a USDCAD low has proved elusive in recent weeks. There is nothing from a wave structure standpoint that inspires confidence but there is the presence of an inverse head and shoulders pattern in the works (since the October 2009 low). Of course, a break above the neckline near 10850 (defended by the 200 day SMA) would be required for confirmation. Additional bullish evidence includes the decline from 13070 coming to an end near the 78.6% retracement of the prior rally and the break above the downward-sloping channel in April.

US Dollar / Canadian DollarInterest Rate Forecast

Despite the BoC raising rates by 25 bps over the past two months markets are looking for an additional 72 bps in tightening. The dimming outlook for U.S. yields has left the spread between the two at a lofty 56 bps which favors additional CAD strength against the greenback. Loonie bulls have pushed the USD/CAD to a five week high with it poised to take another run at parity.

However, we can’t discount the Canadian dollar’s correlation with oil prices which exposes the pair to risk trends. The declining growth outlook for the U.S. could impact the outlook for crude demand as the world’s largest economy accounts for over 20% of total consumption, ultimately weighing on the “loonie”.

US Dollar / Canadian Dollar Valuation Forecast

USDCAD Valuation Forecast: Bullish

A relatively firm interest rate outlook and a strong link to risk appetite amid a rebound in equities has helped the Canadian Dollar add nearly 3 percent in July to push USDCAD into undervalued territory to the tune of 14.5 percent. These supporting factors look to be on the way out, however. Indeed, a Credit Suisse gauge of 1-year rate hike expectations has dropped to the lowest in eight months while the disparity in corporate profits versus revenues hints that the rebound in shares is inherently vulnerable as cost-cutting becomes insufficient to produce earnings growth. Further still, the softening in the US economic recovery bodes ill for Canada considering it sends over 80 percent of its exports across the southern border. On balance, current positioning seems indicative of a buying opportunity, though risk sentiment may yet widen the valuation gap further in the near term before a meaningful correction materializes.

What is Purchasing Power Parity?

One of the oldest and most basic fundamental approaches to determining the “fair” exchange rate of one currency to another relies on the concept of Purchasing Power Parity. This approach says that an identical product should cost the same from one country to another, with the only difference in the price tag accounted for by the exchange rate. For example, if a pencil costs €1 in Europe and $1.20 in the US, the “fair” EURUSD exchange rate should be 1.20. For our purposes, we will use the PPP values provided annually by Bloomberg. We compare these values to current market rates to determine how much each currency is under- or over-valued against the US Dollar.