The oil price remains an important factor where the value of the loonie is concerned but in recent weeks, the bond market has played a far more decisive role in determining the value of the domestic currency.
The first chart is a simple one, merely depicting the U.S. and Canadian two-year government bond yields for the past three years. The difference in trend over the full period is obvious: Domestic yields have been falling – thanks to a huge push by a Bank of Canada rate cut in January, 2015 – and U.S. yields have been steadily increasing.
It's not a coincidence that the trends in the chart correspond with a change in course for the Canadian dollar. When "the spread" – the difference between Canadian and U.S. yields – was large, the loonie was far stronger relative to the greenback. The narrowing of the spread occurred as the loonie fell from its lofty heights.
Relative yields affect currency values because they affect cross-border investment flows. On April 1, 2013, for instance, the yield on the Canadian two-year bond was 0.99 per cent and the yield on the U.S. two-year was 0.24 per cent. U.S. bond investors were motivated to sell U.S. assets and move them into Canadian bonds to pick up an extra yield of three-quarters of a percentage point. In order to buy Canadian issues, these foreign investors had to sell U.S. dollars in fixed income markets, and buy Canadian dollars to make the transaction. The trend resulted in excess demand for loonies and a higher exchange rate.
In the current market, the two-year Canadian yield is 0.65 per cent and the U.S. yield is 21 basis points higher at 0.86. As a result, the process described above is working in reverse. Canadian (and foreign) investors are moving into U.S. Treasury bonds and buying greenbacks to accomplish it.
The second chart shows the direct effects of the yield spread on the value of the loonie. The two lines track far more closely than the domestic currency has been following the crude price (not shown).
Mixed signals from the U.S. Federal Reserve are undoubtedly behind the volatility in the Canadian dollar in the past month. Hawkish signals from the Fed – indicating a rate increase is on the immediate horizon – caused U.S. bond yields to climb. This increases the difference between higher U.S. bond yields and Canadian yields, and the loonie falls. Dovish Fed comments suggesting a rate hike is being postponed have had the opposite effect.
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