Recent data show both domestic and foreign investors fleeing Canadian markets at a record pace. The exodus of investment funds is putting downward pressure on the loonie and, more importantly, pushing bond yields higher at a time when the federal government is looking to borrow more funds.
A research report released on Wednesday by Warren Lovely, National Bank's head of public sector research, noted that "December showed Canadians putting another mountain of capital to work outside the country" as domestic investors acquired $17.4-billion of non-Canadian assets for the month. Mr. Lovely added that "Canadian investors have never before directed as much of their investments to foreign markets as they did in the final quarter of 2015."
The trend was exacerbated by foreign selling of Canadian assets. International investors sold $6.8-billion in domestic bonds in December.
Money leaving the country has a direct effect on the value of the loonie. When a domestic investor invests abroad, there are two behind-the-scenes transactions in currency markets – the selling of Canadian dollars and the buying of the foreign currency necessary to buy the new investment. The selling pressure on the loonie weakens its value relative to other global currencies. The flow of money out of Canada played a big role in the currency's 3.8-per-cent decline during the final quarter of 2015.
The foreign selling of Canadian bonds puts upward pressure on interest rates. Bond prices and yields move in opposite directions, so the downward price pressure caused by foreign selling translates into higher bond yields.
The federal government is in the process of backing away from election campaign pledges to balance the federal budget (rightly, in my opinion), and this makes declining foreign interest in Canadian bonds issues all the more important to the domestic economy.
Larger-than-expected budget deficits will require more government borrowing in bond markets and significant demand from non-Canadian fixed-income investors. This is particularly the case if the government embarks on fiscal-spending initiatives to stimulate the economy. When the government taps the bond market for funds, the interest rate will have to be high enough to attract foreign investment.
There is, to be clear, no impending crisis on the horizon for the Canadian bond market. Interest rates, and thus the costs of borrowing for governments, remain very low by historical standards. In addition, the rally in the U.S. dollar that was helping vacuum investor assets out of the country has abated so far in 2016. The flood of money southward has likely slowed.
However, the record-setting pace of capital flow out of Canada remains an important and disquieting trend for investors to follow for the remainder of the year. If it intensifies, further weakness in the loonie and higher bond yields will become larger problems.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.