What Causes Volatility In The Canadian Dollar?

Canadian Dollar Basics

The Canadian dollar, or currency code CAD, is largely considered one of the world's more stable currencies. It is traded by long-term investors and intraday speculators in substantial volumes, daily. Canadian dollars can be traded outright on the CME Globex futures market, as well as on the forex market via currency pairings. Pairings involving the United States dollar (USD/CAD), and the Australian dollar (AUD/CAD) are a few of the more heavily traded Canadian dollar forex pairings.

According to the International Monetary Fund, the Canadian dollar is the fifth most commonly held currency in the world, with a cumulative market share valued near US$119 billion. The Canadian dollar represents a substantial valuation of the overall world currency markets, and it typically does not experience frequent extremes in pricing volatility as do smaller currencies. However, there are still periods of time where the inherent volatility that faces any currency may bring the perceived stability into question.

The Canadian dollar is defined as being a "floating currency," which derives its value from the open market. The Canadian government does not dictate how much it is worth at a given time, or "peg" its value to another currency; the Canadian dollar's pricing is left to the participants involved in the global currency markets. The value of a "free floating" currency such as the Canadian dollar is constantly evolving. It is not uncommon for the Canadian dollar's value to fluctuate 5-10% in a single trading session.

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The Central Bank Of Canada

The Central Bank of Canada was founded in 1934, and it was very much a product of the Great Depression economic era in the United States.^[1] Functionally, the Bank of Canada's relationship with the Canadian dollar is very similar to the United States Federal Reserve's relationship with the United States dollar. The Bank of Canada operates as the chief financial authority regarding the Canadian dollar; it can raise or lower interest rates related to the Canadian dollar, and it can intervene in foreign currency markets on behalf of the Canadian dollar.

During times of unexpected volatility, the Bank of Canada takes an active role in managing the currency in an attempt to limit huge swings in value. Officially, the Bank of Canada exercises an "intervention policy" when dealing with excessive volatility facing the Canadian dollar. One such "intervention" strategy would be for the Central Bank of Canada to purchase Canadian dollars in foreign exchange markets using foreign currencies. At its core, the strategy's objective is to create a demand for Canadian dollars in these markets, thereby increasing the value of the currency against other currencies. In order to avoid domestic banks hoarding Canadian dollars and creating a shortage, the Bank of Canada deposits an offset of the foreign exchange position denominated in Canadian dollars directly into Canada's economy.^[2] The increased purchasing of Canadian dollars by the Central Bank of Canada can, and often does, increase short-term volatility involving Canadian dollar-related instruments in both the futures and forex markets.

Intraday Volatility: Economic Data Releases

One of the largest factors in the short term, or intraday volatility of the Canadian dollar, is the regimented release of statistical economic data reports. Specifically, the release of statistical economic data from governmental sources can cause large increases in intraday volatility. Numerous domestic economic data releases reoccur every month, while some data releases take place quarterly. Retail sales, Labour Force Survey (the Canadian unemployment statistic), Consumer Price Index and Industrial Price Index are released every month. The Gross Domestic Product is released quarterly.^[3]

The Central Bank of Canada also provides short-term market moving information upon their Bank of Canada Announcements, which occur every six weeks. The Bank of Canada Announcements deal exclusively with the topic of interest rates as they pertain to the inflation of the Canadian dollar.^[4]

Each one of these economic releases has the potential to create a large spike in intraday volume. For instance, the Canadian GDP statistic release dated 1 September 2015 created large intraday volatility for the USD/CAD forex currency pair. Immediately upon the statistic release at 8:30 a.m. Eastern Standard time, the USD/CAD pair sold off from a level of 1.3187 to 1.3126 within seconds. The increase in volume upon the news release created a spike in volatility, and the result was a lightning fast move of 59 pips to the bear. In the current electronic marketplace, market participants can become involved in the market nearly instantaneously. The fast, directional move created by the Canadian GDP statistic example outlined above is a good illustration of the impact that economic releases can have on a currency's pricing and immediate volatility.

Intermediate Term Volatility: Relationship To Commodity Prices

Aside from the release of periodic economic statistics, commodity pricing also affects the volatility of the Canadian dollar. Trade with international partners is a crucial component to Canada's overall economic health. The development and exportation of commodities such as crude oil, natural gas and lumber represent major sectors of Canada's economy. Canada is a net exporter of crude oil. In total, exports represent 45% of Canada's GDP.^[5]

The Canadian dollar's dependence on commodity pricing suggests that there is a relationship between the Canadian dollar to the pricing of crude oil. The decline in crude oil price from the period of August 2014 to January 2015 could be understood as reflecting this relationship between crude oil pricing and the market value of the Canadian dollar. Crude oil prices declined from roughly US$105 per barrel to US$45 per barrel during the period of August 2014 to January 2015. As expected, Canada's overall economy was greatly affected due to the sudden decline in value of an integral part of the energy sector.

At the same time as there was a decrease in crude oil valuation, the Canadian dollar saw a sustained decline in purchasing power as it related to the United States dollar over the same period. The Canadian dollar exchange rate to the US dollar declined from .94 in August 2014 to .80 in January 2015. Overall, this decline in purchasing power represented nearly a 15% depreciation in six months.^[6]

The sustained devaluation of crude oil may have slowed the overall economic growth of the Canadian economy. The intermediate volatility in the Canadian dollar from August 2014 to January 2015 illustrated how the pricing of an important commodity, such as crude oil, could possibly impact currency valuations.

Ultimately, the Canadian dollar is a "floating currency." Due to the fact that the open market decides how much a Canadian dollar is worth, volatility can rear its head at nearly any time. To one investor, volatility can be a nuisance. To another, volatility provides opportunity. Taken in the proper context, the above outlined potential sources of volatility concerning the Canadian dollar could potentially be managed effectively.

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