Canadian Dollar Forecast 2016: Could the Loonie Hit $0.60?

Canadian Dollar Forecast 2016CAD/USD Exchange Rate: Canadian Dollar Forecast Bearish in 2016

Although the Canadian dollar was virtually on par with the U.S. dollar just two years ago, a handful of events have decimated the loonie since. Low commodity prices are threatening to crush the Canadian dollar as the currency was supposed to regain its footing. For many Canadians, dark times lie ahead.

Oil prices fell dramatically last year because of oversupply concerns. The low price environment for crude was particularly devastating for Canadian and American producers that operate with thinner margins than their Middle Eastern counterparts.

Moreover, there’s no guarantee of a strong Canadian dollar even if crude prices rise and bolster oil production. Canada’s already vulnerable economy sustained enormous damage in the last year and a recovery may be too little, too late.

After all, Canada technically entered a recession earlier this year, with small contractions in the first two quarters of 2015. That damage is not easily undone.

Most economists were forecasting an interest rate hike from the Bank of Canada before the oil slump. Today’s unusually low rates are an aberration in Canada’s history resulting from the 2008 U.S.-driven stock market crash.

Low interest rates are supposed to stimulate an economy by encouraging lending, but most analysts and economists thought a return to normalcy was around the corner.

The Bank of Canada wanted to raise interest rates to close that chapter of history. It would have sent an all-clear signal to capital markets that Canada’s economy could survive without support from its central bank. But it never happened.

Why, you ask? The answer is simple: we needed to save the oil industry.

Crude oil was sitting comfortably above $100.00 per barrel when Libyan oil rejoined the global flow of crude. It suddenly dawned on analysts that perhaps oil wasn’t as scarce as was previously believed. Prices cratered over the next few months.

The news was met with dismay in Alberta, the provincial home of Canada’s oil reserves. Layoffs started as a trickle, but soon became a weekly ritual. All around me, colleagues were taking calls from family members who’d suddenly lost their jobs in Alberta.

It was mind-numbing to watch. Months after the Bank of Canada talked about raising interest rates, the Canadian dollar collapsed. Canada’s economy plunged from near-perfect health to the edge of terminal illness.

Canadian Dollar Chart

Chart courtesy of www.StockCharts.com

More than symbolism, the interest rate hike would have helped keep private debt under control. The single biggest threat to the Canadian dollar is the pile of debt sitting on Canadian households.

The Canadian Dollar Jeopardized by Private Debt

Canadian households are absurdly indebted. The level of credit card debt, mortgages, and lines of credit is simply dangerous. What worries us is that Canadians are borrowing more than ever before, but their wages are roughly the same as a decade ago.

How are they affording the debt? Simply put: they can’t. Forget all the hollering over government debt, it’s not half as important as private debt.

As a business journalist, all I hear is how financial institutions could boost profits if lending picks up, or how the Bank of Canada should keep rates low to incentivize borrowing. It’s self-destructive at this point and it puts the Canadian dollar at risk.

Credit has a lot of uses. But the 2008 stock market crash was a story about excessive debt. Do they really want to repeat the mistakes of their southern neighbor?

There are a host of complicated rebuttals in favor of more borrowing. People will borrow money to buy things, and the companies receiving the funds will hire more people, and those people will spend.

A vicious cycle will flourish from initial borrowing, generating enough wealth in the economy to compensate for the debt. Except we keep returning to the fact that wages are not growing.

Abandon the macro view for a moment to consider an individual household with two parents and a child. Let’s call the parents Brandon and Sally, and the child their daughter Michelle.

One day, Sally and Brandon receive an offer from their bank saying they are pre-approved for an extension on their line of credit. The bank is offering rock-bottom interest rates.

Sally and Brandon already have a lot of debt, but things have been rather tight lately, so they accept a small extension on their line.

As the economy picks up, Michelle gets a part-time job working retail. Since she’s always wanted to learn guitar, Michelle uses the extra income to pay for classes.

Years pass. Michelle can play “Smoke on the Water,” but little else has changed. The line of credit remains unpaid, turning into a loan with a higher interest rate. And Sally and Brandon’s monthly payments barely make a dent in the mountain of debt they were convinced was harmless.

This story is all too familiar for many Canadians. People in financial circles think of low interest rates as a tool to strengthen the economy, a stabilizing force for the Canadian dollar when times are bad. And that is true most of the time.

But after the financial crisis, people tried to pay down their debt, not take out more. Canadians are up to their elbows in debt, and no amount of monetary stimulus could help prop up the Canadian dollar outlook for 2016.

Low interest rates are insufficient in this environment.

Mortgage Collapse Could Threaten Canadian Dollar

Before I get to the crux of the issue, let’s consider a few numbers. The household debt-to-income (after taxes) ratio in Canada reached 163.3% by the first quarter of 2015. For every dollar of income, Canadians have $1.63 of debt. That’s crazy! (Source: Canadian Broadcasting Corporation, June 12, 2015.)

Their debt is also taking up an ever-larger portion of the economy.

FRED Chart

The tricky thing about an economic recession is that Canadians may want to pay down their debt, but they find themselves unable to do so. While the growth of their debt so vastly outpaces the growth of their income, Canada’s middle class will continue to drag down the Canadian dollar forecast for 2016.

Now let’s get to the biggest issue in Canada’s economy: housing. We all remember the subprime lending crisis in the United States and how it led to a devastating recession. I say recession, but really the stock market crash ushered us into a state of depression.

The mortgage crisis in the U.S. shattered the popular illusion that home prices rise indefinitely. Housing bubbles are conceived from a cycle of aggressive lending and greed.

Mortgage brokers and banks relax their lending practices, while people allow themselves to be talked into mortgages they cannot afford. But wait, why would mortgage brokers be so foolhardy with their own money?

After all, if homeowners fail to repay, wouldn’t brokers be on the hook? Funnily enough, they wouldn’t. Mortgage brokers and banks pool thousands of mortgages together and create a brand new security that they sell to investors, thus transferring the risk.

The monthly payments are passed through the bank or broker to investors. It’s a brilliant scheme, but the incentives it fosters are incredibly damaging to the Canadian economy.

Under this system, quantity takes precedence over quality. Whoever sells the most mortgages wins. Each new sale pushes up house prices, exciting prospective homeowners who crave the “security” of owning a home. And so the bubble grows.

The Organisation for Economic Co-operation and Development, or OECD, tracks economic data in 34 member countries and provides analysis on long-term trends. The information it has on housing is bad news for the Canadian dollar.

The OECD looked at house prices as they relate to income and the cost of renting. But simply knowing the ratio of house prices to income will tell you very little if you don’t know what the ratio should look like. Has it historically been higher or lower?

Context matters. The horizontal line in the middle of the chart represents each country’s historical average. The blue bars show how far from normal the house price-to-income is right now. Canada’s ratio is 30% above normal. (Source: OECD, last accessed October 2, 2015.)

I’ve heard the counterarguments. Housing demand in urban centres like Vancouver and Toronto are driving a genuine price surge. Houses may be more expensive, but that doesn’t signify a bubble.

Believe that if it keeps you warm at night, but the facts don’t support that argument at all. Look at the price-to-rent ratio. The ratio is 66.3% above its historical norm. If demand for housing is so high, why didn’t rental prices jump as quickly?

People like the concept of ownership. It’s as simple as that. Owning your own home comes at a premium to renting because people want their name on the deed to their residence. The impulse is understandable.

Except, of course; you don’t own a house. You own a mortgage. The bank owns your house and you slowly purchase it from them. But that’s a subject for another article.

The fact remains that Canada has a housing bubble. What happens to the Canadian dollar when the bubble bursts? Nothing good, I can assure you.

Canadian Dollar Forecast: Prepare for the Worst

Ultimately, the outlook for the loonie isn’t great. A housing collapse could devastate the Canadian dollar, but the damage would be incalculably worse when combined with a slump in oil prices. After all, the Canadian economy is founded on natural resources.

Commodities like oil, natural gas, and potash are the backbone of the Canadian dollar. Low commodity prices sap the Canadian economy of its resilience, pushing the loonie to the edge of oblivion.

If Canadians weren’t overextended and overburdened with debt, perhaps monetary policy would work. The Bank of Canada could incentivize spending to fill the gap left by a weak commodities sector, and we’d be fine. Wherever that alternate universe is, it must be nice.

Reality is much harsher than that. We do have a population overburdened with debt. Printing our way out of the commodities glut won’t work, and we cannot shoulder more private debt. All in all, the Canadian dollar is in a dire situation.

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