The US is far and away Canada’s most important export market.  73% of Canada’s exports head south of the border.  As an export market, the US is 15x larger than Canada’s next biggest customer, China, which buys 4.9% of Canada’s export.  But herein lies the paradox: what happens in China is much more important to determining the future of the CADUSD exchange rate than what happens in either Canada or the US.

China’s influence on CADUSD can be observed both directly and indirectly.  At a direct level, accelerating growth in China tends to be followed over the next two years by a stronger CAD, whereas slowing growth tends to be followed by a weaker CAD. CADUSD has a high current and forward correlation to China’s official GDP and an even higher correlation to a narrowly focused (and more volatile) measure of Chinese growth called the Li Keqiang Index, which focuses on rail freight, electricity consumption and bank loans – all strong indicators of the health of China’s commodity-hungry manufacturing sector.

Over the past 15 years, a change in China’s year-over-year GDP growth rate has a correlation of 0.49 with the CADUSD exchange rate level one year later.  For the Li Keqiang measure, the correlation has been even stronger: 0.57 (Figure 2).  Also, notice that when Chinese growth decelerates, the Looney often falls 6 to 18 months later, and the opposite tends to happen when China’s growth accelerates.

China’s influence on CADUSD is also apparent when observed indirectly, through the commodity prices that exert such a strong influence on CADUSD’s movements.  One can apply the same sort of analysis seen in Figures 2 and 3 (calculating the correlation between the Li Keqiang Index at time T and subsequent price levels for a given instrument) to all the primary materials in our trade weighted Canadian commodities index.

With a few exceptions such as canola, zinc, gold and lumber, which together constitute a 19% weight in the index, all of the price levels other commodities show strong correlations to what our narrow measure (the Li Keqiang Index) of China’s economy was doing one year prior.  In much the same manner as CADUSD, when China’s economy accelerates, their prices tend to rise and when China’s economy slows, their prices tend to fall (Figure 4).  CADUSD might be the exchange rate between the currencies of Canada and the US but many of its key component parts are “Made in China.”

In addition to the importance of commodities in determining the level of the CADUSD exchange rate and the key role that Chinese growth plays in the value of those commodities, there is a second reason why China exerts such a strong, if indirect, influence on the exchange rate: the US and Canadian economies are otherwise quite similar. Both enjoy similarly low rates of inflation (Figure 5).  Unemployment usually trends in the same direction (Figure 6).  Central bank policy, though occasionally divergent, tends to head in the same general direction (Figure 7).  Yield curves and GDP usually track one another (Figures 8 and 9).  To the extent that the US and Canadian economies diverge, its often because of Canada’s greater reliance on natural resource exports – and the most important determinant of natural resource export prices has been the pace of growth in China.

Looking beyond China and commodities, two factors that could contribute to divergence between the Canadian and US economies are real estate prices and debt.  Canada avoided the real estate bubble that afflicted the US economy during the middle of the last decade but may have developed one of its own.  In recent years, Canadian real estate prices have hit a wall, while US prices have continued climbing (Figure 10).  If Canadian real estate prices were to fall – a possibility given the apparent tightness of Bank of Canada’s monetary policy— that could put downward pressure on Canadian rates and CAD relative to their US counterparts.

Its not just the Canadian housing market in isolation that is of concern. The rapid increase in Canadian house prices up until 2016 was driven by a sharp rise in household debt. Canadian household debt now totals 100.8% of GDP, according to the Bank for International Settlements (BIS), compared to just 75% of GDP in the US. Canada’s current level of household debt exceeds what the US saw even in the lead up to the 2008 financial crisis. Canada also has much higher corporate debt that the US (118.7% of GDP versus 75% in the US). Total Canadian debt has risen to much higher levels than in the US (Figure 11).

This isn’t to suggest that Canada is by any means on the verge of a financial crisis. The 2008 financial meltdown in the US was brought about by a combination of collapsing real estate prices, high levels of private sector debt and a monster tightening cycle that saw the Fed raise rates 17 times from 1% to 5.25% between 2004 and 2006. Bank of Canada rates are still only 1.5% but even at that level they might be high enough to slow growth and increase mortgage defaults. Canadian housing prices aren’t falling yet but, if they do Bank of Canada might have to get rates back towards zero in a hurry. The good news for Canada is that public sector debt is somewhat smaller than in the US (79.4% of GDP versus 99.8%) which could afford Canada some latitude for fiscal stimulus if the economy slows too much.

• Most of CADUSD variance can be explained by commodity prices
• China is the main driver of both commodities and CADUSD
• Reliance on natural resource exports is the main difference between Canada & US
• In other most respects, US and Canadian economies are similar
• Canadian private sector debt levels are much higher than in the US
• Canadian housing prices have stopped rising