By Michael O’Neill

Many Canadians will soon be asked if they enjoy the smell of melting steel, nickel, and brass—the composition of the Canadian one-dollar coin. This stems from the recent gains in the Canadian dollar that seem increasingly unsustainable.

Economic Outlook Comparison

Compared to the US, Canadian economic growth is far weaker. Foreign investors are avoiding the country, productivity is sharply lower, and the Bank of Canada is lowering interest rates. Canada and the United States have distinct but similar economic growth outlooks, with the US generally expected to outperform Canada. The Organization for Economic Cooperation and Development (OECD) forecasts for Canadian GDP are 1.0% in 2024, rising to 1.8% in 2025, while the US will see GDP growth of 2.6% in 2024 before dropping to 1.8% in 2025.

Resilience to Economic Shocks

The question is: which country is better situated to withstand an economic shock? The US wins hands down due to its larger population and a more diversified economy, which allows for a wider range of industries and sectors to drive growth. The US is the banker to the world, and it benefits from its position as a global economic powerhouse. Additionally, the US has a history of technological innovation and entrepreneurship, fostering a culture of risk-taking and creativity. This environment promotes the growth of high-tech industries and encourages the development of new sectors that contribute to economic expansion

Canada’s Vulnerability

Canada’s reliance on resource-based industries, such as oil and gas, leaves it vulnerable to supply disruptions and price shocks, exacerbated by current government energy policies. Foreign Direct Investment (FDI) in Canada peaked at $74.9 billion in 2014 and has bounced erratically since, falling 6 out of 10 times. One reason is the global economic uncertainty exacerbated by the U.S.-China trade tensions and the COVID-19 pandemic. Supply chain difficulties are still being felt, and with former President Donald Trump as the front-runner in the 2024 election, it is unlikely that trade tensions will ease. These events have caused investors to become more risk-averse, leading to reduced capital flows into Canada.

Government Policies and Investment

FDI will continue to struggle because of the Canadian government’s corporate tax and anti-oil policies. Canada’s relatively high corporate tax rates compared to the US are a competitive disadvantage as Canadian corporations pay an average of 26.5% compared to 21.0% in the US.

 The anti-oil policy is a bigger barrier. The government has decided to transition from fossil fuels to net zero emissions by moving to renewable energy. The plan is to leave $12.8 trillion of proven oil reserves in the ground while spending $103 billion on clean energy investments between 2023 and 2035, according to the Parliamentary Budget Office. Simply put, Canada wants to transition from the reality of existing infrastructure to the fantasy of a broad, country-wide, zero-emitting power grid, funded by unlimited cash from the magic money tree.

Productivity and Investment

The weak FDI numbers translate into lower productivity due to lower investment in key technologies, according to the Fraser Institute. “From 2014 to 2022, output per hour worked, a common measure of labour productivity, increased at an average rate of 1.35% in Canada, while it increased at an average annual rate of 1.78% in the US.

“Crucially, during those same years, investment in IT (information technology) was 10.4% of total investment in Canada compared to 16.5% in the US. Investment in research and development and other intellectual products was more than double in the US—27.7% of total investment compared to Canada’s 12.6%.”

Bank of Canada’s Stance

Bank of Canada officials are well aware of Canada’s productivity shortfall. Deputy Governor Carolyn Rogers spoke at length about this issue at the end of March. She noted, “When you compare Canada’s recent productivity record with that of other countries, what really sticks out is how much we lag on investment in machinery, equipment, and, importantly, intellectual property. The global economy continues to change rapidly, and in many sectors, it’s not machinery and equipment that are key—it’s investment in intellectual property. Increasingly, companies need to own or have the rights to patents that will allow them to compete by adopting productivity-boosting processes.”

Weak investment has been a problem in Canada for a long time. You can go back 50 years and find a persistent gap between the level of capital spending per worker by Canadian firms and the level spent by their US counterparts. However, the situation has become worse over roughly the past decade. While US spending continues to increase, Canadian investment levels are lower than they were a decade ago.”

Interest Rate Spreads and the Loonie

Another key question is whether the Loonie will get any support from narrowing CAD/US interest rate spreads. Both central banks are downshifting. The Bank of Canada was first off the mark with a 25 bp cut in June, and they are widely expected to repeat the process on July 24. Those odds improved on July 11 after a soft US inflation report. The US data helps the Fed justify cutting its benchmark rate on August 1. Bond traders are betting on such an outcome, as evidenced by the Canada/US 10-year yield spread narrowing to -74 bps today.

USDCAD has been locked in a 1.3550-1.3850 range since April 10, 2024. Its inability to sustain any downside momentum combined with bullish daily technicals above 1.3590 and elevated geopolitical risks keeps the focus on further gains toward 1.4000.

If so, you may get to experience the smell of the Loonie burning.