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scott barlow

I've been wrong about the loonie for the past two weeks, but I'm not quite ready to give up yet. The domestic currency has been more closely tracking the oil price than government bond yields after I argued repeatedly that bond yields were the better indicator.

The two accompanying charts track the one-year path of the loonie against the oil price and against the spread between the two-year government bond yields of Canada and the United States. The relationship is close in both cases (this is backed up by correlation analysis), but there's been an apparent change in pattern beginning Feb. 25. On that date, the bond market began signalling a pullback for the loonie but the currency continued to rally along with the oil price.

One reason to be suspicious about the newer "oil-is-the-better-loonie-indicator" theme is the currency has been rising ahead of the oil price, not the reverse. The top chart shows the rally in the loonie started on Jan. 19 and continued through a significant 22-per-cent pullback in the oil price that ended on Feb. 11.

If the loonie were tracking the oil price, it's highly unlikely its rally would start three weeks before oil. Also, if the crude price were driving the loonie, why wouldn't the loonie follow it lower during the correction?

The second chart provided a more compelling explanation for the Canadian dollar's performance in the past 12 months. In this case the loonie was the follower, tracking the yield spread lower from Oct. 15 to Jan. 12. The abrupt change in direction for the yield spread coincided exactly with the beginning of the loonie rally on Jan. 19.

And then we have the big divergence. From late February, the spread between the Canadian and U.S. two-year bonds tightened (the orange line on the chart moved lower) while the loonie continued higher. This is the primary reason why I don't trust the rally in the Canadian dollar past that point. As noted above, the yield spread has been leading the exchange rate. If that theme continues, the grey line in the lower chart is likely to head lower to meet the orange line representing the spread.

Where the loonie is concerned, there is another wrinkle not shown on the charts. The Canadian to U.S. dollar exchange rate recently climbed to a level above its 200-day moving average (200DMA). This is an important indicator for technically focused traders that distinguished between assets trading in either long-term downtrends or upturns. The breach above the 200DMA for the loonie is a technical sign that the currency may be starting a sustainable new uptrend. The 200DMA, then, implies a drop for the loonie is less likely.

Admittedly I'm speculating here, drawing conclusions from small samples of data. I still believe, however, that in global markets dominated by central-bank policy (as the volatility after the ECB announcement proved again Thursday), bond markets provide the best forward-looking indicator for the Canadian dollar.

Follow Scott Barlow on Twitter @SBarlow_ROB.