The loonie is sharply lower this week and it's time to figure out why. A closer look at the "usual suspects" that have been driving the currency – commodity prices and relative bond yields – indicate that fixed income markets are behind the move.
The loonie has fallen well over a cent against the U.S. dollar so far this week. At first I was so sure it was because of the slide in China's equity markets – the loonie is viewed as a commodity currency by global investors and weakness in China often leads to selling in Canadian dollar assets – that I didn't bother looking further. This was a mistake. While the loonie was falling, the Australian dollar – which has much closer ties to Chinese activity and asset markets – rallied significantly. The strength in the Aussie dollar strongly implied that China was not behind the move lower in the loonie.
Another place to look in order to understand the fall of the domestic currency is oil markets. The West Texas intermediate crude price did fall Monday and could have contributed to loonie weakness. But it's also evident from the first chart, below, that the relationship between oil prices and the Canadian dollar hasn't been all that tight lately. In addition, Tuesday saw a rally in oil prices while the loonie fell further.
The lower chart provides a far more plausible explanation for the recent drop in the Canadian dollar. The chart compares with value of the loonie with the difference between U.S. and Canadian two-year government bond yields. This is known as the "two-year spread." Calculating it is simple – just take the yield for the Canadian two-year bond and subtract the yield from the two-year U.S. Treasury bond for each day.
The Canadian dollar has tracked changes in the yield spread far more closely than the oil prices over the past two years. Changes in cross-border asset flows is the reason this makes sense. Investor assets – both retail and professional – gravitate toward higher yielding bonds.
For example, at the moment, the yield on the U.S. two-year bond is 63 basis points and the yield on the Canadian two-year is 50 basis points. Canadian investors looking to maximize income in the two-year market are more likely to buy U.S. bonds to increase the income by 13 basis points. This process involves selling Canadian dollars in currency markets, weakening the loonie, and buying the U.S. dollars necessary to purchase the higher-yielding U.S. bond.
Eric Burroughs, an editor at Reuters, believes that the release of Canadian gross domestic product data Tuesday also had a negative effect on the loonie. Mr. Burroughs notes that trading volume on Canadian bonds was very heavy after the GDP report and it's his opinion that many institutional investors had bullish bets on the loonie, were caught offside by weaker than expected growth, and were forced to sell their Canadian dollar investments.
Yield spreads are playing an important role in driving the currency now, but they are likely to take on increasing significance as talk of another Bank of Canada interest-rate cut intensifies. Canadian bond yields will fall as another rate cut becomes more probable. This will increase the yield advantage of U.S. bonds and cause more weakness in the Canadian dollar.