However, investors should recognize that exchange rates tend to be long-trending markets, regularly entering different regimes but consistently varying more than their underlying fundamentals. This is often related to the particular macro regime a country enters.
In the case of Canada, the recent commodity boom created a steady wave of capital inflows, driving down yields and boosting the currency—a self-reinforcing cycle that drove the currency to lofty levels. Now all this is heading in reverse. However, the key point is that swings in the currencies are almost always far wider than differences in output and inflation.
A variety of underlying factors drive these moves. In simple terms, currencies can be looked at as the “stock” of a particular country. A firm currency reflects a confident view in the quality of its fiscal situation.
In practice, currency forecasting methodologies and models vary widely. Some approaches focus on the concept of purchasing power parity—the level at which two countries are broadly competitive with each other given prevailing inflation rates. Others concentrate on measures of relative economic strength and resulting portfolio flows, i.e., a more attractive country growth profile will attract greater investment flows, creating demand for the currency and driving it upward. Still others examine trade flows and attempt to determine the “equilibrium” exchange rate that brings a country’s current account into balance.
All of those are important factors. However, currencies can and do become wildly overvalued and undervalued—just like stocks. Why shouldn’t investors view this opportunistically?
Examining investor sentiment is also critical. In financial markets, public opinion is usually unified and dead wrong at major inflection points, becoming too exuberant after prices have risen and too gloomy after they have fallen. Currencies are no different. Extremes in opinion often register shortly before major changes in trend.