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Weaker CDN $ helps offset “COOL effect”

The Markets

I’ve received a few inquiries lately in regards to the outlook of the Canadian dollar and how a stronger U.S. greenback influences local cattle prices. The Canadian dollar recently dropped to four-year lows against the U.S. dollar and it appears the trend is not over. We have seen a drop in fed cattle exports to the U.S. since November largely due to COOL, while feeder cattle exports remain sharply above year-ago-levels. At the same time, wholesale boxed beef prices are trading near historical highs, enhancing demand for processed beef products south of the border. So what is ahead for coming months?

Currency values are largely determined by monetary policy of the central governments. Since the recession of 2009, the U.S. Federal Reserve was buying longer-term bonds in an effort to lower interest rates for housing purchases and stimulate the economy. The activity of buying bonds drives up the bond price but lowers the yield. For example, when a person locks in their mortgage for a five-year term, it is based and sometimes hedged on a yield of a five-year government bond and that is why there are costs if you need to break this mortgage term.

Without going into detail, we have now seen the U.S. government ease its bond-buying program (known as Quantitative Easing), causing bond prices to decrease and yields increase. The U.S. Federal Reserve has been buying $85 billion in bonds a month but this program will decrease to $75 billion in January. Longer term, this bond-buying volume will slowly decline as the economy improves. What does this have to do with the Canadian dollar?

Bond — U.S. Bond

If bond yields or interest rates are increasing in the U.S. while Canadian yields are staying the same, the currency needs to reflect this change; otherwise there is an arbitrage opportunity. Very simply, if interest rates are the same in each country, then there is no benefit to change one currency into another currency because the return after one year is the same. If one currency has a higher interest rate, there will be a financial incentive to change the currency into the other currency and receive the higher rate. However, financial markets are extremely efficient and when bond yields increase in the U.S., the Canadian dollar weakens so that their is no arbitrage opportunity.

Another factor driving exchange rates is the demand for Canadian dollars versus demand for the U.S. greenback and this is largely due to trade. For example, when petroleum countries repatriate their U.S. funds, there is usually a bounce in the Canadian dollar because they sell the greenback and buy Canadian dollars. The Canadian dollar is largely resource-based on crude oil, gold and metals and the gold and metals made their highs in the first half of 2011 and have been declining since then.

Under a normal trading environment, a weaker Canadian dollar would enhance the values of feeder cattle and fed cattle. U.S. buyers would have a stronger currency, giving them more buying power so cattle in Canada and the U.S. are priced the same at the U.S. destination. When this article was written in early February, we had not noticed a sharp decline in the exports of fed cattle since COOL started to influence the overall market in early December.

COOL effect

We have seen the basis for fed cattle become more volatile, but it is also important to note U.S. cattle prices have been trending higher. Certain packers have been caught short and the additional costs of labelling are built into the price. The retail beef market is also developing under COOL as there is uncertainty how the U.S. consumer will respond longer term.

The market may not realize the full effect of the weaker loonie in the short term because of the uncertain market conditions related to COOL. Local basis levels from a specific plant can also become extremely volatile when extreme adverse weather influences a certain cattle feeding region. In any case, if we look at the market theoretically, after factoring in the “COOL discount or COOL effect,” the weaker Canadian dollar should enhance prices for fed cattle and wholesale boxed beef moving to the U.S. or offshore longer term.

Feeder cattle exports during 2013 were up 133 per cent over 2012. COOL is having a limited effect on feeder cattle finished in U.S. feedlots. There is additional demand surfacing for Canadian feeder cattle due to the stronger buying power of the U.S. greenback relative to the Canadian dollar. Canadian feeder cattle prices have been lagging the U.S. market but this spread should narrow longer term, which is good news for cow-calf producers.

The Federal Reserve quantitative easing program will decline through 2014, causing U.S. interest rates to increase. This will cause the Canadian dollar to weaken against the U.S. greenback. Looking at previous history, the Bank of Canada lags the U.S. by approximately six to eight months so we can probably expect a marginal increase in Canadian interest rates in late 2014.

Canadian fed and feeder cattle prices will be enhanced by the weaker Canadian dollar longer term.

About the author

Columnist

Jerry Klassen

Jerry Klassen is manager of the Canadian office for Swiss-based grain trader GAP SA Grains and Products Ltd. and also president and founder of Resilient Capital, a specialist in commodity futures trading and commodity market analysis. He can be reached at (204) 504-8339 or visit his website at www.resilcapital.com.

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