I wrote recently that the Canadian dollar was the most predictable asset value on earth and appeared fairly valued relative to bond yields and the oil price.
Canaccord Genuity strategist Martin Roberge, however, has a much different view – he warned Canadians to prepare for a loonie at 70 cents (U.S.).
Mr. Roberge's methodology is based on economic surprise indexes, which measure economic data reports relative to consensus expectations. A rising line on a surprise index, for instance, means that the most important economic data releases feature results that are ahead of expectations.
In the first chart below, Mr. Roberge is arguing that taking the level of the Citi economic surprise index for Canada, and subtracting the economic surprise index for the United States, produces a resulting value that predicts the value of the loonie.
Currently, the value of the domestic currency is well above where it should be in light of the surprise indexes. Canaccord believes the loonie, the orange line on the chart, will fall toward the grey line, representing a major decline for the Canadian dollar.
The surprise indexes are not the only reason Mr. Roberge expects weakness for the loonie.
"While Ottawa and the Liberals are back running budget deficits," he writes, "Canada's trade balance remains deep in the red despite a marked depreciation of the [Canadian dollar]." This trade deficit means more money flowing out of the country, selling Canadian dollars to buy foreign currencies in the process, and a dampening effect on the currency.
The second chart shows the value of the dollar relative to the two-year yield differential between government of Canada and U.S. Treasury bonds. Roughly speaking, it shows the loonie is fairly valued right now.
Despite the difference in our methodologies, there is nothing inherently contradictory about the two charts. The lower chart implies the dollar is where it should be now, but Mr. Roberge's chart is attempting to predict the future. The weakness he sees in the economic surprise indexes now, if it continues, will have a downward effect on the two-year Canadian bond yield. This will push the orange line on the second chart lower, and the loonie will follow.
The use of surprise indexes to predict currency values is a really interesting one that I haven't seen before. It allows investors to connect a real time view of economic growth – the surprise indexes are updated daily – to interest rate and currency markets. Along with oil prices and bond yields, it appears to offer an effective tool to gauge the future of the domestic currency.