The failure of the Federal Reserve to test a June high in the USD/CAD rate has left many investors feeling jittery about what the future will hold. There is reason to believe that a big move in the currency of this country could signal that the exchange rate might spike higher.
Central banks are all over the map when it comes to choosing the best timing for their foreign policy decisions. It is all about trying to react to the developing economic environment.
Central banks, with their target prices, do not want to be caught out when the dollar rises and the markets look bad. And they know that having the currency of this country rally significantly before the decision is made, does not bode well for the future.
The reality is that central banks are caught in a complex bind and are reluctant to engage in open market operations as this would make the situation much worse. When markets look like they are sliding and the government realizes that it will take quite a bit of time to get the economy back on track, they will change their strategy.
Even so, it will be extremely difficult for central banks to maintain their current inflation targeting policy even if the dollar weakens significantly. In this scenario, they have to change their policies and the effect this will have on the currency values is obvious.
As an example, you can see the chart below showing the range within which the price of the dollar/CAD rate has stood. It indicates that it has varied between about 90 and 115 at various points in the past two years.
When the currency falls sharply, central banks fear that it will do more damage to their ability to keep the values stable. This is reflected in the fact that some central banks are finding it difficult to remain “neutral” between the USD/CAD rate and the spot rate.
It should be noted that not all central banks are acting in the same way. While others are taking a neutral stance and waiting to see how the market reacts, others have opted to move in either direction.
One reason why the dollar/CAD rate has been staying out of favour with many investors is that the exchange rate is highly volatile. It is not stable.
The short period where the exchange rate is highly volatile is after a recession is over, when this has yet to be decided, and when the budget deficit is still rising. In these periods, the market volatility is out of control.
It is important to remember that central banks have an interest in keeping the value of the dollar high because they are trying to balance the US budget. This in turn makes the dollar stronger and thus allows them to meet their objectives in a far more disciplined manner.
As the world economy continues to become more uncertain, the governments of the various countries are faced with a situation where they must have flexibility and the ability to respond to changing economic circumstances. They do not want to be caught up in a downward spiral and use their power to prop up their currencies.