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scott barlow

The effects of central bank monetary policy on bond yields are likely to determine the value of the loonie, and investors should follow the path of the two-year bond closely.Jeff McI

Consensus forecasts on central bank monetary policy and North American bond yields will see the Canadian dollar fall below 75 cents (U.S.) in 2018.

The past five years have seen the loonie's value closely track the relative yields of Canadian and U.S. government two-year bonds. The previously close relationship between the domestic currency and the crude price has broken down in recent years, although quick changes in the commodity price still have effects.

The first chart below plots the path of yields for the two-year bonds for Canada and the United States. In the 2012-14 period, domestic yields were considerably higher than U.S. yields and this coincided with a loonie trading at an average of 96 cents in U.S. dollar terms.

The link between the loonie and bond yields concerns cross-border asset flows. When Canadian yields are higher than their U.S. counterparts, global portfolio managers sell more U.S. bond holdings to buy Canadian bonds.

This process involves converting U.S. dollar proceeds from Treasury sales to Canadian dollars – creating a bid for loonies in foreign exchange markets – to buy domestic bonds to benefit from the bigger yield. (The oil price was also high for most of the 2012-14 time frame, which increases foreign capital into Canada as the Americans pay more for oil imports, but we'll get to that below).

Canadian and U.S. yields are both heading higher, with help from central bank rate hikes on both sides of the border. But, as the second chart highlights, the loonie's value depends on which yields are moving the fastest. The light-blue line represents the spread – the Canadian two-year yield minus the U.S. yield – and the purple line plots the Canadian dollar.

The exchange rate is moving almost exactly with the spread (and this is verified by correlation calculations).

For comparison purposes, the third chart illustrates the effects of the oil price on the Canadian dollar. A reasonably close relationship is apparent, but divergences have been larger and more common in the past five years than between the loonie and yield spreads.

Currently, the government of Canada two-year bond yield is 1.8 per cent, the two-year Treasury yield is 2.06 per cent, which makes the spread 26 basis points (this is updated from the chart, which shows weekly data). The loonie stands at 80 cents against the greenback.

The consensus economist view is that the Canadian bond will end 2018 with a 2.06-per-cent yield and the two-year Treasury will be 2.42 per cent at the end of December. This would leave a spread of 36 basis points, which is significantly wider than conditions now, implying a weaker loonie.

The last time domestic two-year bonds yielded 36 basis points less than U.S. two-years, the Canadian dollar was 8 cents lower, at 72 cents.

The obvious question here is: But when was the last time economists were right about bond yield forecasts? My answer is: I can't remember that far back. Investors can safely assume the estimates will be off based on recent history, but we don't know in which direction – the spread could be much higher than currently forecast, which means an even weaker loonie.

Gluskin Sheff economist David Rosenberg expressed his outlier opinion that the Bank of Canada is done raising rates for the year in a recent interview – the consensus view is for two more hikes. If Mr. Rosenberg is right, then the estimates for the Canadian two-year bond yield are too high, the spread is likely to be much bigger than 36 basis points, and the loonie could be even lower than 72 cents by year end.

No matter who's right, or wrong, the effects of central bank monetary policy on bond yields are likely to determine the value of the Canadian dollar, and investors should follow the path of the two-year bond closely.

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