Skip to main content

I wrote about the loonie a mere 10 days ago but things have already changed, and not for the better. The recent slide in oil prices, combined with a Merrill Lynch report suggesting bond markets will also help push the domestic currency lower, means the loonie could fall a lot further than previously expected.

Stated simply, the problem is that markets expect the Federal Reserve to raise interest rates as early as September, and also believe the Bank of Canada will go the other direction and cut interest rates in early 2016.

Merrill Lynch economist Emanuella Enenajor recently wrote: "Economists are forecasting [an] interest rate divergence … but we think the Street is simply underestimating how much more room USDCAD [U.S. dollar vs. Canadian dollar] has to run higher in an environment of weak Canadian growth and divergent monetary policy."

A rate hike in the United States will make American bond yields more attractive to global investors (including Canadians) and this is likely to push the U.S. dollar higher against all global currencies. A Bank of Canada rate cut will do the reverse, make government bond yields less attractive and push the loonie lower. The possibility that both these events will happen within months might combine to drive the loonie to deeper depths than younger Canadians have ever seen.

The accompanying chart shows the extremely close relationship between the relative two-year bond yields of Canada and the United States, and the value of the Canadian dollar. The orange line is simply the Government of Canada two-year bond yield minus the U.S. Treasury two-year yield.

A falling orange line on the chart means Canadian bonds are yielding less compared with their U.S. counterparts. A negative reading, as we've mostly had since February, means Canadian bonds carry a lower yield than U.S. two-years.

The premise behind the connection between yields and the loonie is that when Canadian bonds yield a lot more than U.S. bonds, this attracts more foreign investment, which supports the value of the domestic currency.

The chart suggests that the current value of the Canadian dollar is roughly in line with bond yields. However, economists do not expect current conditions to continue.

The median forecast for the U.S. two-year bond yield for the first quarter of 2016 is 130 basis points (1.30 per cent), which takes the probability of a Fed rate hike into account. The median forecast for Canadian two-years is 79 basis points. This makes the potential difference between the two yields – the spread – 51 basis points. According to the chart, this would put the loonie in the 70 cent (U.S.) range in early 2016, about 7 cents, or 9 per cent, lower than today.

This scenario is of the "all other things being equal" variety. Commodity prices still play a major role in driving the value of the Canadian dollar. A recovery in crude prices would limit the damage suggested by the bond yield forecasts. Further significant declines in crude, however, combined with bond markets, could result in a remarkably low loonie – 65 cents, in that event, would not be out of the question.

But even a 70-cent loonie will not happen unless both the Federal Reserve and Bank of Canada act on interest rates. That said, until there's more clarity, Canadians should expect the domestic currency to remain weak.