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How a strong loonie could see mortgage rates jump

A major divergence in bond and currency markets suggests that, either the Canadian dollar is set for a sharp fall, or five-year bond yields are set to climb. Canadian homeowners should be hoping for a weaker loonie.

The chart below illustrates the important role of government bond yields in determining the value of the domestic currency. The black line shows the spread between Canadian and U.S. five year bond yields plotted against the value of the loonie (red line). The correlation using three years of daily data is exceedingly high at 0.86 (R-squared 0.74).

The reason for the close connection is straightforward. Global investors, including Americans, buy more Canadian five year bonds when the yield is significantly higher than five-year U.S. Treasuries in order to get their higher coupon payments. This creates demand for Canadian dollars in currency markets.

The lines on the chart began diverging in April, by the widest margin in the last three years. Canadian bond yields declined markedly against Treasuries, but the loonie failed to follow suit.

SOURCE: Scott Barlow/Bloomberg

It is reasonably safe to assume that global investors will arbitrage (or "arb out") the divergence in the chart. Hedge funds, for instance, might build short positions in the Canadian bond market paired with long futures positions in the U.S. dollar–value of the loonie. Investments like these would help close the gap on the chart – pushing the loonie lower and domestic bond yields higher.

For Canadian homeowners and real estate investors, the five-year government of Canada yield is all important because it's the biggest driver of mortgage rates. The current currency-to-bond yield market anomaly would resolve if the Canadian dollar declines against the greenback, which will present no problem for the domestic real estate market.

The chart also implies upward pressure on bond yields, however. If that becomes a trend, mortgage rates will rise, and pressure on the Canadian real estate market – which many believe is set for a sharp correction – will intensify.

Follow Scott Barlow on Twitter at @SBarlow_ROB.

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