The U.S. Federal Reserve is arguably the most powerful financial entity on the planet and if, as many economists believe, chair Janet Yellen raises interest rates this week, the Canadian dollar will be front and centre among assets likely to be pushed around in the aftermath.
Sovereign debt markets have a clear and undeniable effect on the value of the loonie. Specifically, the difference in yield between the Government of Canada two-year bond and the two-year U.S. Treasury has tracked the value of the Canadian dollar even more closely than the price of oil.
The reasons for the relationship between bond yields and the loonie are straightforward. Income-hungry investors, both domestic and global, will buy the government bond with the higher yield.
In September, 2013, for instance, the two-year Government of Canada bond yielded almost a full percentage point more than the two-year Treasury. This attracted global investment assets into the Canadian bond market and, because foreign investors must sell their own currency and buy Canadian dollars before buying our bonds, this created demand for the Canadian dollar and pushed its value higher.
Whenever it happens, a Federal Reserve interest rate increase will cause immediate volatility in bond and currency markets. The current yield differential between Canadian and U.S. two-year bond yields is minus 0.24 percentage points – Canadian bonds yield 24 basis points less than Treasuries of the same maturity.
The two-year U.S. bond yield will rise immediately after a 25-basis-point rate hike, (although likely by a smaller than 25-basis-point amount). The rate differential between U.S. and Canadian bonds will increase from minus 0.24 to somewhere in the minus 0.30 range (and I'm speculating a bit there) if the domestic bond yield stays near current levels. This would make U.S. bonds even more attractive to global (and Canadian) investors than they are now.
In this scenario, the loonie will fall by a significant amount relative to the greenback. A 70-cent (U.S.) Canadian dollar, even if just temporary, will become a distinct possibility.
The extent of the loonie's fall will be determined in part by whether the Government of Canada two-year bond yield moves higher in sympathy with the U.S. bond market. Climbing Canadian bond yields would not be great for the Bank of Canada, which is trying to keep yields low to pressure the loonie and increase exports. Higher domestic bond yields would, however, mitigate the U.S.-versus-Canada yield differential resulting from a Fed interest rate increase.
Merrill Lynch North American economist Emanuella Enenajor has added an additional wrinkle to this investing conundrum. Ms. Enenajor believes the Bank of Canada is set to cut domestic interest rates in October. This would force Canadian bond yields lower. The potential combination of a U.S. rate hike and a Bank of Canada rate cut could increase the yield differential with U.S. bonds to much more negative levels, and send the loonie on an even steeper dive.
The sheer number of moving parts in bond markets will make this Thursday's Fed meeting a fascinating event for market watchers. It's impossible to predict how bond yields on either side of the border would react to either a change in interest rate policy or a significant change in the language in the statement that accompanies the decision. In the end, the loonie should move in accordance to the two-year bond yield differential between U.S. and Canadian two-year bonds.
Follow Scott Barlow on Twitter @SBarlow_ROB.