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Here's what the most accurate measure of the loonie's fair value is saying right now

Scott Barlow

Globe and Mail Update

The most accurate measure of fair value for the loonie has been the difference between Canadian and U.S. bond yields and, according to this indicator, the domestic currency is trading where it should be.

The problem now is that bond yields themselves may be out of line.

The two charts below highlight that while oil prices have a significant effect on the Canadian dollar, the value of the loonie has a closer association with relative bond yields. This is supported by correlation calculations.

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The first chart compares the value of the Canadian dollar with the relative yields of Canadian and U.S. government bonds – simply the yield on the two-year Government of Canada bond minus the two-year U.S. Treasury bond yield. The recent Bank of Canada rate hike, and the warnings ahead of the official announcement, have pushed domestic two-year yields sharply higher, narrowing the yield spread relative to Treasuries.

On June 8, the Canadian two-year bond yielded 60 basis points fewer than the comparable U.S. bond.

This gap has now closed to seven basis points. (A basis point is one-100th of a percentage point.)

The value of the loonie has improved right along with the yield differential, rising from 74 cents (U.S.) to 80 cents for the same period.

The increase in domestic bond yields is, to some extent, in anticipation of further central-bank rate increases. Bloomberg calculates an 82-per-cent probability the Bank of Canada moves again before the end of 2017, and a 22-per-cent chance of two rate increases, using futures and options pricing.

Citigroup interest-rate strategist Jason Williams is among those who believe the market is overestimating the potential for higher Canadian interest rates and bond yields.

In a July 21 report, Mr. Williams wrote, "we find it unlikely that the BoC can move faster than the already steep expectations by the market. … The BoC will also see some challenges to tightening much further given that the Canadian dollar has materially strengthened."

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Mr. Williams went on to note that he agrees with Citi's economists that "the Canadian economy may not be ready for aggressive monetary policy normalization."

If Citi is correct, and it is far from alone in its view (Credit Suisse also sees the loonie as overvalued), then Canadian bond yields are likely to fall. This will cause the grey line in the top chart to drop also – Canadian yields will be lower relative to U.S. comparables – and the domestic currency will likely weaken. Hawkish U.S. Federal Reserve signals would exacerbate this move by pushing U.S. yields up while domestic yields fall.

The upward move in Canadian bond yields still has considerable momentum – the 10-year bond showed a 2-per-cent yield on Wednesday for the first time since November, 2014.

The second chart, however, comparing the loonie and the oil price, shows the currency is extremely overvalued by that measure, and the interest-rate-related fundamentals underpinning the recent rally in the Canadian dollar may be far more fragile than the markets believe.

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