Foreign exchange, or forex, trading is an increasingly popular option for speculators. Ads boast of "commission-free" trading, 24-hour market access and huge potential gains, and it is easy to set up simulated trading accounts to practice trading techniques.

With such easy access comes risk. Forex trading is a huge market, but every forex trader is competing with thousands of professional analysts and other knowledgeable professionals many of who work for major banks and funds. The foreign exchange market is a 24-hour market, and there is no exchange – trades take place between individual banks, brokers, fund managers, and other market participants. Artificial intelligence has also changed the forex market in recent years with the introduction of predictive analytics models and machine-learning capabilities, all of which help forex traders to gain a huge advantage.

Forex is not a market for the unprepared, and investors should do thorough homework before entering the market. In particular, would-be traders need to understand the economic underpinnings of the major currencies in the market and the special or unique drivers that influence their value.

The Canadian Dollar

Just seven currencies account for over 80% of the volume of the forex market, and the Canadian dollar (often called the "loonie" because of the appearance of a loon on the back of the C$1 coin) is one of these major currencies, and is the fifth-most held currency as a reserve [1]. For more information of currency trading, see Top 7 Questions About Currency Trading Answered.)

The Canadian dollar's currency ranking is somewhat of an anomaly as Canada's economy (in terms of U.S. dollars of GDP) is actually 10th in the world [2]. Canada is also relatively low on the list of major economies in terms of population, but it is the 11th largest export economy in the world, according to the Observatory of Economic Complexity hosted by MIT [3]. The Canadian dollar was not part of the original Bretton Woods system. It floated freely until 1962 when extensive depreciation toppled a government, and Canada then adopted a fixed rate until 1970 when high inflation prompted the government to move back to a floating system.

All of the major currencies in the forex market are supported by central banks. For the Canadian dollar it is the Bank of Canada. As with all central banks, the Bank of Canada tries to find a balance between policies that will promote employment and economic growth while containing inflation. Despite the significance of foreign trade to Canada's economy (and the influence that currency can have on trade), the Bank of Canada does not intervene in the currency – the last intervention was in 1998 when the government decided that intervention was ineffective and pointless. (For more, see Get To Know The Major Central Banks.)

The Economy Behind the Canadian Dollar

Ranked tenth in terms of GDP (measured in U.S. dollars) in 2017, Canada has enjoyed relatively strong growth over the last 20 years with two relatively brief periods of recession in the early 1990s and 2009. Canada has had persistently high inflation rates, but better fiscal policy and an improved current account balance have led to lower budget deficits, lower inflation and lower inflation rates.

In analyzing the economic situation in Canada, it is also important to consider Canada's exposure to commodities. Canada is a meaningful producer of petroleum, minerals, wood products and grains, and the trade flows from those exports can influence investor sentiment regarding the loonie. As is the case for virtually all developed economies, this data can be readily found on the internet through sources like the Agriculture and Agri-Food Canada website. (For related reading, see Economic Factors That Affect The Forex Market.)

Although the average age of Canada's population is high compared to global standards, Canada is younger than most other developed economies. Canada has a liberal immigration policy, however, and its demographics are not particularly troubling for the long-term economic outlook.

Because of the tight trading relationship between Canada and the United States (they both make up over half of the other's import/export market), traders of the Canadian dollar watch the events in the United States. While Canada has pursued very different economic policies, the reality is that conditions in the United States inevitably spill over into Canada to some extent. (These conditions also influence other economic phenomena such as inflation. For more, see How The U.S. Government Formulates Monetary Policy.)

What is particularly interesting about the U.S.-Canada relationship is how conditions can diverge. The structure of Canada's financial market helped the country avoid many of the problems with bad mortgages that affected the United States. On the other hand, technology companies are less significant to Canada's economy, and this led to relative weakness in the Canadian dollar during the tech boom in the United States in the 1990s. Also, the commodity boom of the 2000s (particularly in oil) led to an outperforming loonie. (For more, see 5 Steps Of A Bubble.)

Drivers Of The Canadian Dollar

Economic models designed to calculate the "right" foreign currency exchange rates are notoriously inaccurate when compared to real market rates partly because economic models are typically based on a small number of economic variables (sometimes just a single variable such as interest rates). Traders, however, incorporate a much larger range of economic data into their trading decisions, and their speculative outlooks can move rates just as investor optimism or pessimism can move a stock above or below the value its fundamentals suggest. (For more, see 4 Ways To Forecast Currency Changes.)

Major economic data includes the release of GDP, retail sales, industrial production, inflation, and trade balances. This information is released at regular intervals, and many brokers as well as many financial information sources like the Wall Street Journal and Bloomberg make this information freely available. Investors also take note of employment, interest rates (including scheduled meetings of the central bank), and the daily news flow – natural disasters, elections, and new government policies can all have significant impacts on exchange rates.

As is often the case with countries that rely on commodities for a sizable portion of their exports, performance of the Canadian dollar is often related to the movement of commodity prices. In the case of Canada, the price of oil is particularly significant for currency moves, and investors tend to go long on loonies and short on oil importers (such as Japan, for instance) when oil prices are moving up. Similarly, there is some impact on the loonie fiscal and trade policy in countries like China – countries that are major importers of Canadian materials. (For more, see Canada's Commodity Currency: Oil And The Loonie.)

Capital inflows can also drive action in the loonie. During periods of higher commodity prices, there is often increased interest in investing in Canadian assets, and that influx of capital can impact exchange rates. That said, the carry trade is not so significant for the Canadian dollar.

Unique Factors for the Canadian Dollar

Given the relative economic health of Canada, the country has a somewhat high interest rate among developed economies. Canada also enjoys a newly-won reputation for balanced fiscal management and finding a workable middle path between a state-dominated economy and a more hands-off approach. This is relevant during periods of global economic uncertainty – though not a reserve currency like the U.S. dollar, the Canadian dollar is considered a global safe haven. (For more, see The U.S. Dollar's Unofficial Status as World Currency.)

While the Canadian dollar is not a reserve currency at the level of the U.S. dollar, this is changing. Canada is now the fifth most commonly held reserve currency and those holdings are increasing.

The Canadian dollar is also uniquely tied to the health of the U.S. economy. Though it would be a mistake for traders to assume a one-to-one relationship, the United States is a huge trade partner for Canada, and U.S. policies can have significant influence over the course of trading in the Canadian dollar.

The Bottom Line

Currency rates are notoriously difficult to predict, and most models seldom work for more than brief periods. While economics-based models are seldom useful to short-term traders, economic conditions do shape long-term trends.

Though Canada is not a particularly large country and is not among the largest exporters of manufactured goods, the country's economic vitals are stable, and the country has found a balance between profiting from its natural resource wealth and risking "Dutch disease" from over-reliance on these goods. As Canada becomes an increasingly viable alternative to the U.S. dollar, traders should not be surprised to see the loonie become more important in the forex market. (For related reading, see 3 Factors That Drive The U.S. Dollar.)