U.S. dollar rising, but can't match the loonie

A sea change in currency markets is giving the U.S. dollar a boost in relation to other world currencies, but the shift has not been at the expense of the Canadian dollar.

To the contrary, the loonie continues to strengthen against the greenback and looks poised to outperform most major currencies in 2010.

"We are really into a period right now where the currency market is searching for a new formula," says John Curran, senior vice-president of CanadianForex. "Rather than the panic flight to quality and the risk on/risk off trade that has been in vogue since the collapse of Lehman Brothers, people are starting to rely more on fundamentals and are becoming more focused on interest rates moving forward."

Investors are beginning to speculate the U.S. dollar will strengthen against most major currencies, figures show.

At the end of December, investors were net long the U.S. dollar for the first time since last April, with the aggregate net long position hitting US$1.6-billion on the Chicago Mercantile Exchange, according to a report yesterday.

The recent strength of the greenback comes at the expense of the Japanese yen, the British pound and most strikingly, the euro, which has fallen 5% since late November against its U.S. counterpart and is now the largest net short position held against the U.S. dollar at US$6.1-billion.

Meanwhile, the Australian, New Zealand and Canadian dollars gained strength against other world currencies, with the loonie now boasting the largest net long position against the U.S. dollar at US$3.8-billion.

"Sentiment has violently shifted against the euro, while it has remained bullish the Canadian dollar and the other commodity currencies," said Camilla Sutton, currency strategist at Scotia Capital Markets, in a note to clients.

She expects the loonie to stay strong over the next 12 months, outperforming other major currencies and hitting parity with the greenback mid-year before settling at US97¢ near year-end.

Yesterday, the loonie closed at US96.25¢, up US0.23¢.

"Rising commodity prices, particularly for oil, which recently broke back above US$80, along with relatively stronger economic fundamentals, reasonable growth prospects, a more controlled deficit and a large commodity base are all supportive of the Canadian dollar"

In addition, she expects the Bank of Canada to start raising interest rates at the same time as the U.S. Federal Reserve, which will prove a neutral driver for the Canadian dollar against the greenback.

As the Canadian dollar soars, the euro is showing visible signs of cracking as recent events, including sovereign credit deterioriation in Greece and Spain and a lack of fiscal progress in France and Italy, shine a light on the continent's many structural challenges

Making matters worse for the euro and other major currencies like the yen and the pound, is recent U.S. economic data that continues to support a V-shaped recovery south of the border thus fuelling speculation that interest rates will rise in the United States sooner than is expected across the Atlantic.

Just yesterday, Scotia Capital Markets noted that U.S. factory inventories, which came in better than expected on Tuesday, continues to support 6-8% real U.S. GDP growth in the fourth quarter.

"U.S. rates will rise relative to many other countries, including the euro zone,"

"This will undermine some of the financial incentives that has made the dollar a favored funding currency and will see the risk-on/risk-off theme disintegrate and the dollar will find better traction."

"It will be difficult for the euro to mount a sustainable rally, but ultimately sees a U.S. dollar that will close this year at lower levels than it closed in 2009. Despite evidence of the V-shaped recovery, the pressures against the U.S. dollar are real."

"Large and growing deficits, a dovish central bank and a shift away from the U.S. dollar as a reserve and trade currency are not generally the recipe for currency strength over the medium term,"