FEA lowers Canadian dollar forecast by 8% for 2014-2028 period on lower oil prices, more expensive terms of trade in Canada, tightening US monetary policy; USD per CAD exchange rate projected to trough at US$0.86 in 2017, average US$0.97 from 2019-2028
March 11, 2014
(Forest Economic Advisors LLC)
– In late 2013, FEA lowered our near-term forecast for the Canadian dollar, citing the following factors for this decision:
1) We lowered our near-term oil price forecast due to tepid global demand growth, surging US production, as well as the growing discount for Canadian oil relative to the WTI benchmark.
2) Canada will need a weaker currency to erase its persistent current account deficit. This deficit has been largely driven by Canada’s deteriorating terms of trade (the ratio of export prices to import prices). As Graph S1 shows, the value of the loonie has tracked Canada’s terms of trade quite closely over the last several decades and it remains elevated. Canada’s terms of trade have risen by 22% since early 2002. The Bank of Canada estimates that about half of this increase was due to commodity prices and most of the rest was due to decreases in non-commodity import prices.
3) US monetary policy has shifted to a tightening bias (albeit a modest one), while the Bank of Canada’s has remained unchanged. Moreover, whereas Fed statements and forecasts have primarily painted a picture of an improving economy, BoC communications have focused on the downside risks to growth and expected inflation.
4) We noted that over the long-term, exchange rates typically gravitate towards their purchasing power parity (PPP) level. A PPP exchange rate is derived by comparing the costs of two identical baskets of goods in two countries. According to the IMF, the PPP exchange rate for the Canadian dollar is 81 US cents. This means the loonie is currently overvalued by 11% on a fair-value basis. We noted that we were reluctant to show our USD per CAD forecast gravitating back to its PPP level over the long term because the US Energy Information Agency showed real oil prices trending up over the next two decades, and we generally try to keep our oil price projections reasonably close to theirs. Thus, our long-term loonie forecast struck a balance between an appreciating trend driven by rising real oil price and a depreciating trend driven by the historic tendency of exchange rates to trend toward their PPP level over the long term.
The Long-Term Oil Price Picture Suddenly Looks Rosy
The 2014 Annual Energy Outlook report from the US Energy Information Agency shows a sharp downward revision to the long-term price trajectory for inflation-adjusted WTI oil prices relative to the 2013 report. As Graph S2 shows, the EIA has lowered oil prices by about 10% per year between 2013 and 2030 on a compound annual basis.
The EIA cited two primary reasons for the more optimistic (from the standpoint of consumers) oil price forecast. First global supply of both oil and natural gas (a partial substitute for oil) is expected to increase sharply thanks to 1) robust increases in US production, and 2) the widespread adoption of unconventional drilling techniques pioneered in North America. The 2014 AEO forecast for the year 2025 shows global supply of crude oil at 19.19 quadrillion Btu. By comparison, the 2013 AEO showed a supply of 14.5 quadrillion Btu. This is a 32% adjustment in just one year!
The second main reason for downward revision to long-term oil prices is that demand for oil in the advanced economies is expected to grow more slowly than previously anticipated, thanks to increased energy efficiency and changing trends in transportation. For an example of the latter, in the US total vehicle miles driven have remained at recession lows for the past five years (Graph S3). We do not see figure recovering to its previous level any time over the next 20 years.
We agree with much of the reasoning in the 2014 AEO report from the EIA and have adjusted our long-term oil price forecast down by a similar amount (Graph S4). We have not adopted the EIA forecast wholesale because FEA prefers to construct cyclical forecasts rather than the trend-line versions preferred by the EIA.
We Have Lowered our Canadian Dollar Forecast by about 8% for the 2014-2028 Period
The combination of lower oil price projections and the knowledge that exchange rates tend to gravitate toward their PPP level over the long term has prompted us to cut our long-term forecast for the Canadian dollar by about 8% on average over the next 15 years (Graph S5).
Despite the downward revision to our oil price forecast, we still note that long-term oil prices are expected to trend upwards over the last decade of our 15-year forecast horizon. As a result, we still expect the loonie to appreciate over the bulk of that period (Graph S6). However, prior to that, we expect tepid oil price growth combined with the higher US growth and interest rates relative to Canada and deteriorating terms of trade in Canada to put downward pressure on the loonie over the next five years. We would not be at all surprised to the USD per CAD exchange rate hits its fundamental value of 81 cents sometime over the next few years.
• We have lowered our forecast for the USD per CAD exchange rate over the whole range of the 15-year forecast period. We project that it will trough at 84 US cents in 2017 and that it will average 97 cents from 2019-2028.
• The main reasons for the downward revision are 1) lower oil prices; 2) more expensive terms of trade in Canada; 3) tightening US monetary policy relative to that of Canada; and 4) the tendency of currencies to gravitate towards their PPP level over the longer term.
• The US Energy Information Agency lowered their long-term oil price projections by about 10% over the next 15 years and FEA has followed suit with a similar downgrade.
• In our long-term forecasting (2019-2028), the return to the PPP level near 81 US cents was complicated by the fact that real oil prices are projected to trend upward. The lower oil price projections are the primary driver of the relatively weaker Canadian dollar that we are showing for the 2019-28 period.
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