The Canadian dollar (CAD) is characterized by its strong connection to commodities. This is supported by the fact that the Canadian economy heavily depends on the trade of gold and oil. There is a direct correlation between the prices of commodities and the general welfare of domestic producers.
Since a big percentage of Canadian exports are directed to the US, there is a strong relationship between Canada and USA. For the year 2006 the US has gotten 76.5% of Canada’s exports, and even though this is down from the 85% share it had just six years ago, this information leads to the conclusion that the Canadian economy is heavily linked to the US one.
For example, if the US economy experiences an upturn, more trade activities with Canada will be executed, which in turn will lead to an upturn in the Canadian economy. Alternatively, a downturn in the US economy will result in less trading activities with Canada, which will be reflected in a potential downturn in its economy as well.
The geographic proximity of the US and Canada results in an increased number of mergers and acquisitions. This is significantly facilitated due to the globalization trend that has been observed recently. The currencies’ values are greatly influenced by the resulting flows of money. The mergers and acquisitions of Canadian companies lead to an increase in the value of the Canadian dollar, since more of it is needed, which is done through the selling of the USD.
Traders focus their attention to the interest rate differentials between the Canadian cash rates and the short term interest yields of other countries. Interest rate differentials present the amount of premium yield that is offered by short term CAD$ fixed income assets as compared to foreign short term fixed income assets. Thus, they can be used as an indicator of the future cash flows. Since forex traders aim at assets that provide the highest yield differentials provide them with a view on the future movements in the price of currency pairs.
The lending or buying of a currency that enjoys a high interest rate and the borrowing or selling of a currency that suffers low interest rate is referred to as carry trading. Since the Canadian dollar is a popular currency for carry trading, as a result the value of the Canadian dollar has increased. This has been additionally fostered by the high interest on the part of foreign investors for assets that offer high yields.
A decrease in the interest rate differential between the CAD$ and foreign currencies will result from an eventual increase in interest rates by global central banks. This will lead to carry traders closing their positions and a pressure on the Canadian dollar will be put on.
