"It's a Bull Market Jim, but not as we know it"

Two of our graduate trainees were recently given a project of looking at the unusual strength of the Canadian dollar. What follows are their words and work. It is a great example of the idea that if you give creative and talented people enough space and time, they can amaze you with their ingenuity and intelligence. In italics, this is what they wrote...

"As popular legend has it, the mission of the starship Enterprise was to 'explore strange new worlds', 'seek out new life and new civilisations', split the infinitive and 'boldly go where no man has gone before'. The episodes were in part an allegory for the burgeoning social pluralism of 1960s America. True to form, when the central trio of Captain James T. Kirk, 'Bones' McCoy and Mr Spock encountered 'strange new life', the stock catchphrase of the half-human Mr Spock was: 'It's life, Jim, but not as we know it.'

An example of 'strange new life' has been discovered in the currency markets of late. The Canadian dollar (known affectionately as the 'loonie'), which had nestled at around US$85¢ during the first quarter, has been something of a one-way bet since early April, appreciating to US$95¢. Some analysts expect the currency to reach parity with the US dollar for the first time since 1976. How are we to classify this recent trend? Is the bull run being driven by fundamentals or sentiment? Having already sold our position, should we take Newton back in?

Opening our Economics 101 textbook to the section entitled 'currency - appreciation' and with thinking-caps on, we began to construct a regression model. We took the Bank of Canada target rate as our base ingredient. To this we added a splash of US Federal funds target rate; a hint of Canadian CPI inflation; a twist of the current account balance; a measure of Canadian GDP; and we cooked ourselves a half-way decent indicator. But it wasn't enough. Something more was required, a certain 'I-don't-know-what'. Consulting the historic import/export payments we noticed that oil and gas make up an increasing proportion of Canadian foreign revenue. A trawl of industry rags and Reuters gossip showed that the 'loonie' is regarded as a commodity-based currency. Accordingly, we threw the MSCI Canada Energy Stock Index (for the oil/gas revenue exposure) and Brent crude price (as a proxy for sentiment) into the mix. Voila! Out popped a coefficient of determination (R2) of 0.964 for the period 1 Jan 1997 to date.

The chart suggests that, based on past data, the recent appreciation of the Canadian dollar is unjustified, pulling sharply above our regression-implied fair value and breaking out of the confidence interval boundaries. But could our model be broken? Is there an exogenous factor at work?

The world is currently in the grip of a liquidity-driven merger and acquisition wave, sweeping Canada along with it. Because merger and acquisition transactions are large and lumpy, they can upset capital flows and impact currency markets. Moreover, unlike past merger cycles, this round seems to be financed with cash rather than equity à la dot.com. Data on the level and timing of Canadian mergers and acquisitions, therefore, might suggest an explanation for the upturn in the 'loonie'. An examination of the evidence shows that the rapid appreciation of recent weeks does indeed coincide with a splurge of merger and acquisition activity. The first half of the second quarter in 2007 saw C$111bn of deals announced, compared with C$66bn in the first quarter, a 69% increase on an already high figure (but in half the time). The question whether the heightened demand for the increased Canadian dollar-based merger and acquisition activity is already priced in, or whether the 'loonie' has further to go, remains open but the pipeline of deals announced this year - equivalent to 8% of the listed TSX market cap - cannot be sustained indefinitely. Cue Mr Spock: 'It's a bull market, Jim, but not as we know it.'"

What our graduate trainees have correctly recognised here is the power of pure money flows. As we have discussed in these pages before, the aggressive reorganisation of global reserve money is happening at a more rapid pace than has been generally appreciated. It is, in its nature, both anti-bond and anti-US dollar. Or to put it another way, both pro-equity and pro-other currencies. More to the point, on the equity side, it doesn't care for collecting portfolios of shares that are managed by fund managers. It wants to own entire companies. It was, for instance, reported in the press this week that the Qatar royal family had upped its stake in the supermarket company Sainsbury's to 25% and if you look around you, you can see many other examples of direct ownership that is fuelling the private equity boom.

Canada has oil. Although difficult to extract in some places, it has oil. According to some estimates (see above), it has 7% of the world's reserves. Strategic purchases by countries like China into oil and oil-related companies shouldn't come as a surprise in that case. But, through the Canadian dollar, we have just had an example of how an excess of deal flows can drive a currency beyond what any reasonable theoretical model would predict.

We should expect that other commodity countries will experience the effects of similar strategic shifts which, in turn, will drive their currencies going forwards. The Australian dollar comes to mind in particular. However, in the meantime this process appears to have gone too far too quickly and so we are reducing our Canadian dollar exposure. But one day, we will return because this is a trend you really shouldn't stand in the way of forever.