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A former Goldman Sachs economist has proposed a new method for judging fair value for the loonie, so of course it's time to test it out.
The spot oil price and relative bond yields have been the best indicators of the Canadian dollar's price movements in recent years. Josh Crumb, founder and chief strategy officer for financial technology firm GoldMoney Inc. and formerly a senior metals strategist at Goldman Sachs, argues that the long-term outlook for crude prices, not the spot price, is a key driver.
In short, here's what I've found: Mr. Crumb is right and we now have an important new benchmark for the Canadian dollar.
I've noted previously that relative bond yields – the Canadian two-year bond yield minus the two-year U.S. Treasury yield – have been the most powerful determinant of the loonie's value in the past three years. This remains the case as the relationship between this two-year spread and the dollar remains extremely close according to correlation calculations.
Thanks to Mr. Crumb, the discovery for me is that the price of five-year oil futures is a better indicator of changes in the loonie's value than the spot crude price. The difference is very slight, making it difficult to display with charting, but fascinating nonetheless.
The correlation between the loonie and the thinly traded five-year oil future is higher than with the loonie and the spot oil price. This is extremely surprising given the market's general short-term focus, perhaps best exemplified by rabid interest in quarter-over-quarter corporate profit growth.
Mr. Crumb believes that because the five-year futures markets are dominated by highly informed oil producers, hedging future sales rather than hedge funds and speculators, and less affected by short-term inventory issues, it is a better reflection of energy markets and the price outlook. This is why the connection between the futures markets and the Canadian dollar is so close.
Applying the new futures benchmark, I am now slightly more bearish on the loonie in the short term. In April, I noted that the Canadian dollar looked a bit undervalued relative to the oil price but overvalued based on bond yields. If I use the spot oil price the loonie would still look undervalued, but as shown in the first chart below, relative to the five-year crude futures price, the loonie is fairly valued. This means that the loonie is overvalued relative to bonds and fair value in terms of oil, which is less bullish for the currency.