In 1970, the value of the Canadian dollar ("loonie") was floated against other world currencies to fight inflation. Since that time, it has evolved into a global reserve and benchmark currency that is followed by economists. The behavior patterns of the loonie versus the U.S. dollar (USD) on currency exchanges afford indirect insight into the actual and projected economic conditions in both countries. The case can be made that evidence gained by such analytical methods provides a more realistic gauge than that collected through direct observation. (For background reading, see Canada's Commodity Currency: Oil And The Loonie.)

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Since reaching an all-time low against the USD in January 2002, the loonie has risen as the U.S. economy has faltered and the price of oil has increased. The two dollars historically moved in tandem, but that link has lost strength over the past decade largely due to dramatic fluctuations in oil prices and fears of inflation within the United States. Canada is a major oil and commodities exporter and greatly benefits from price escalations.

Recent Developments
More recently, the Bank of Canada has signaled that it might raise interest rates, possibly as early as June. The U.S. Federal Reserve has consistently pledged to keep rates low until the economy can sustain itself without such rates. This has resulted in a strengthening of the loonie relative to the USD since higher interest rates attract more foreign investment, increasing the demand for the Canadian dollar.

The interrelationship of these two currencies is of great interest to Canadians and Americans alike. Over half of all Canadian imports come from the U.S. and over three-quarters of its exports go to the United States. So it's clear that the exchange rate is of significant concern to both sides of the border. (Find out more about correlations in forex. Check out Using Currency Correlations To Your Advantage.)

Impact on Exports & Imports
All other things being equal, the rise in the loonie relative to the USD will result in lower demand and fewer sales for Canadian products in the United States. This is because Canadian exports will cost more to U.S. importers. In order to maintain the same level of sales volume, Canadian exporters would have to lower their prices. Either way, lower volume or lower prices will result in lower revenue to Canadian companies.

Canadian importers benefit from a rising loonie since they get more bang for their buck. Imports become relatively cheaper, and that benefits Canadian retailers selling American products. If the retailers maintain their current prices on American products, they experience increased profits since their purchase costs are now lower. Or, if they reduce prices, they would likely increase sales volume and possibly offset the loss in profit per unit. This helps Canadian consumers because American goods cost less in comparison.

In addition to cheaper imports of finished products, the stronger loonie benefits Canadian industries that purchase raw materials outside the country. That allows them to reduce manufacturing costs and either increase profits or pass some of the savings on to consumers. The investment capital of Canadian businesses looking to expand beyond their borders will have greater purchasing power. This may allow them to buy foreign businesses that they couldn't afford before.

To U.S. exporters, a rising loonie is good news because their products appear cheaper to Canadians, likely leading to more purchases for American manufactured goods. The U.S. exporters can do this without actually reducing their prices stated in USD, so they receive the same amount per sale, resulting in higher revenues and profits for American companies exporting to Canada.

With the implosion of the housing bubble, U.S. real estate has become far more attractive to Canadian investors. Armed with the stronger loonie, Canadians have looked south to purchase second homes and vacation retreats in areas featuring warmer climates. This may help to stabilize prices in areas hardest hit such as Arizona, Florida, Nevada and California. The loonie's appreciation has also spurred more Canadian tourism in the U.S., an industry that was severely impacted by the recession. The downside to Canada is less Americans traveling north.

The Bottom Line
The Bank of Canada currently has no established target value for the loonie, and its formal position is that its value should be determined by prevailing market conditions. Since Canada has weathered the recent economic storm better than the U.S., the loonie has reached parity with the USD and could go even higher. Much hinges on the ability of the U.S. to deal with its struggling economy, crushing debt and the unfunded liabilities of its entitlement programs.

Feeling uninformed? Read this week's financial news highlights in Water Cooler Finance: Buffett's Armed and Greece Keeps Falling.

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