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Canadian dollar update -- caution warranted

The Canadian dollar has reached parity with the US once again. There's a lot going for it these days, and it shows, since the loonie is about as strong relative to the US dollar as it's ever been. That's the message of the first chart, which compares the spot price of the loonie (blue line) to my calculation of its purchasing power parity (green line). The gap between the two is pretty large, which suggests a significant "overvaluation" of the loonie.

The loonie has lots of fans because it is a "commodity currency" as the second chart shows. The loonie has traditionally been highly correlated to commodity prices, since Canada is a major producer of commodities. Commodity prices have been on a tear for over a year, and so has the loonie. Canada as a whole also looks pretty good relative to the US of late, since the country has largely avoided the banking crisis that the US is struggling with. (See this post which explains why: the Canadian government has for the most part avoided meddling in the housing and mortgage market.)

When the news is uniformly good, and the price of the beneficiary of the good news is historically high, that is the time to be cautious. Things might continue to improve, but then again they might not. At these levels, the loonie is very vulnerable to any news that is short of very good. It needs the good news to continue just to hold its current valuation. I'm not sure what might go wrong, but bad news has a tendency to come when you least expect it, and from a direction that nobody is watching. The loonie could go up some more, or it could hold at these levels for another year, and I wouldn't be surprised at all. But the risks are skewed to the downside in my opinion, so I would not want to be aggressively long the loonie.

Full disclosure: I have no exposure to the Canadian dollar at the time of this writing.

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