EclectEcon

As I write this, the Candian dollar seems to be worth about 85 cents (US). This is near the highest US price of a loonie that we've seen for many, many years. One reason the US price of a loonie has been so high lately is that the price of oil has been high, and, like it or not, the Canuck buck borders on being a petro-currency. [digression: my colleague, David Laidler, has argued for decades that the value of Canadian currency has been determined, in large measure, by world prices for raw materials and resources, which Canada has a comparative advantage in producing and exporting].

Hahn Investments thinks the Canadian dollar value is about to fall relative to the US dollar. Their argument is seven-fold, but one of their main points is that it is unusual for Canadian interest rates to be below the U.S. interest rates; when this happens, one might expect short-term capital to flow to the U.S. and out of Canada, thus pushing down the U.S. price of a Canadian dollar.

I think their position ignores two important additional, related considerations (which may explain why, according them, most economists do not agree with their forecast):

1. Expected Inflation. If people expect that the twin deficits in the U.S. will lead to more inflation there than in Canada, then it makes sense that they might send their short-term capital to Canada despite Canada's lower interest rates. Interest-rate parity is important, but it embodies inflationary expectations, too. To see this, just compare Spanish, Italian, Swiss, and Japanese interest rates.
   
   
2. And this raises the second point. Despite its recent growth, many reasonable people think the U.S. economy is headed for trouble. The large gubmnt deficits and the large current-account deficits lead, at the very least, to growing uncertainty about the strength of the U.S. dollar in the near future. And this uncertainty induces people to hold more Canadian currency than they might otherwise.
   

In other words, it is possible that Hahn has placed too much emphasis on short-term interest rates as indicators of what might happen in the future and not enough emphasis on short-term interest rates as indicators that have already discounted people's expectations about the future. The former view says the interest-rate differentials will lead to downward pressure on the Loonie; the latter view says the interest-rate differentials will persist because of changes in the underlying strengths of the Canadian and U.S. economies.

I am fairly pessimistic about the short-term future for the U.S. dollar, and that is one of the reasons I'm more optimistic about the Loonie than Hahn is. At the same time, though, you might wish to consider Bill Polley's forecast that the U.S. dollar will gain a bit of strength over the next year.

Well, he also predicts that Canada will defeat the U.S. in curling at the Olympics, so at least he got that one right.

Update: For more reasons to be skeptical about the future strength of the U.S. dollar, see Kip Esquire and Econbrowser. At the same time, as a commenter notes, other currencies do not look terribly strong, either.