Bond markets, not the oil price, have been the dominant driver of the loonie's value in recent years but the Brexit result has, for the time being, broken the relationship. Global markets were blindsided by the U.K. referendum outcome and the divergence between bond yields and the loonie could be temporary. It's also possible, however, that a new risk-off era has begun and the loonie is poised to weaken.
The two-year spread – the difference in yield between the Canadian and U.S. two-year bond yields – has been more closely tied with the value of the loonie in recent years. As the yield on Canadian bonds dropped below their Treasury counterparts, the loonie weakened. Foreign and Canadian investors were motivated to divert assets from Canadian fixed-income markets toward U.S. markets in order to increase income.
The chart below shows how well this has worked. The orange line is the simply the yield on the Canadian two-year minus the yield on the two-year U.S. bond. The changes in this value mirror the path of the loonie (grey line) almost exactly.
The pattern changed on Friday. U.S. bonds rallied as investors dove for cover from post-Brexit equity risk, taking Treasury yields lower. Canadian bonds, meanwhile, were largely unchanged and spreads tightened. Under normal circumstances, the Canadian dollar would have rallied as domestic yields improved relative to American yields. Instead, the loonie fell and a sharp divergence appears at the end of the chart.
Canada is a proudly G7 nation but globally, the loonie is historically viewed as a risk currency because of the high equity-market weighting in volatile resource stocks. More recently, fears surrounding overheated housing markets, and the economy's sensitivity to disappointing U.S. growth have foreign investors even more concerned about the loonie.
It's early days in the post-Brexit era and normally I wouldn't make so much out of a reflexive, one-day move in markets after a major event. However, there are reports that the RBC morning conference call for brokers highlighted a warning from the markets that sellers of Canadian bonds among the bank's institutional clients outnumbered buyers by a 10-to-one margin in the early hours of Friday.
Later Friday, RBC chief economist Craig Wright wrote, "A return to risk aversion in financial markets is expected to put downward pressure on oil prices, government bond yields, and the Canadian dollar [relative to the greenback]."
The loonie fell against the greenback Friday despite the fact that, with Treasury yields falling closer to Canadian levels, the Canadian dollar would normally rise. This suggests investor risk aversion.
Nervous foreign investors are likely to require a bigger pick-up in yields before buying domestic bonds instead of U.S. dollar issues. Despite the current Canadian economic slowdown, lower foreign demand for Canadian bonds could create upward market pressure on domestic interest rates – the last thing a weak economy needs.
Again, the U.K.'s decision to leave the European Union is new and shocking, and it will take time for markets to digest the implications. The initial reaction to these kind of events is often exaggerated and it would be a mistake to extrapolate Friday's market action too far. Nonetheless, it does seem safe to say that the loonie will be weaker until global market volatility subsides.