The Bank of Canada has a problem: Bank Governor Stephen Poloz was counting on a weak currency to boost exports and drive the economic recovery but things haven't gone entirely his way.
The USD/CAD started the year around 1.06, rose to about 1.12 in March and has since fallen back to around 1.06. In Q1 the CAD was the world's worst performing major currency, with a total return of -3.5 percent vs USD; in Q2 it was the best performing G-10 currency, with a total return of +3.8 percent.
The reason for the currency's good performance is that investors became more confident about Canada's outlook as the U.S. economy accelerated and energy prices turned up. According to the Commodity Futures Trading Commission (CFTC) Commitment of Traders report, speculators had been considerably short CAD since early 2013, but in the most recent reporting week they flipped to being a tiny bit long (about 2,700 contracts). It's not much, but the fact that they're no longer short is significant.
However, this could be the case of a self-destroying prophecy. Everyone knows a self-fulfilling prophecy: when all investors think something is likely to happen, for example that gold is going to go up, then they buy gold and of course it go up! A self-defeating prophecy would be the opposite: one that might go right, but since everyone acts on it, it goes wrong. That's what I believe is going to happen here.
The Canadian economy is indeed improving, but a good part of that improvement is due to exports. The latest Business Outlook Survey showed that the Canadian economy's biggest hope remains overseas demand, particularly from the U.S. Exporters seemed notably more optimistic about the future than companies supplying the domestic market. So the Bank of Canada has to keep the currency from appreciating in order to keep the recovery going. Governor Poloz, who was previously the head of Canada's export-promotion agency Export Development Canada, naturally understands this.
The Bank's dilemma is that the inflation rate is over its 2 percent target. The Bank also looks at core inflation, to get a feel for where the overall CPI is going. Core inflation isn't yet at 2 perecnt, but it's rising. So the Bank has to be worried about meeting its inflation target. And that's another reason why people are buying the CAD: they think there's a chance the bank could change its stance to be less even-handed and more concerned about inflation.