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The year ahead is going to get nasty for the loonie

The following is an excerpt from Scott Barlow's collection of 10 charts that will define the markets in 2017. To view the entire series, click here.

The Bank of Canada and the U.S. Federal Reserve are moving in different directions and this is likely to result in a lower Canadian dollar for 2017.

The price of oil has a significant impact on the loonie but interest rates have been the better predictor of the domestic currency's value in the past five years. Specifically, the yield on the Canadian two-year government bond minus the yield on the two-year U.S. Treasury bond has been almost foolproof as a fair value indicator for the Canadian dollar, as the chart below shows.

Cross border investment flows are behind the trend. Domestic and foreign investors will shift assets to higher-yielding bond markets. In April, 2012, for instance, the two-year Canada bond yielded 1.42 per cent compared with 0.25 per cent for the U.S. equivalent bond. U.S. bond investors moved assets to the Canadian market to receive higher yields. As part of this transaction, these foreign funds were converted to Canadian dollars in foreign exchange markets, pushing the loonie's value above par on the greenback.

Current trends in Canadian bond yields are very negative for the loonie. Fed chairwoman Janet Yellen's recent decision to increase U.S interest rates pushed the orange-coloured line on the chart lower. Fed policy caused U.S. bond yields to rise relative to Canadian bond yields. The Bank of Canada is not expected to change policy in 2017, but if it does, the most likely action is an interest rate cut. This would also make domestic bond yields less attractive relative to U.S. bonds and weaken the loonie. In other words, central bank policy on both sides of the border is leaning towards a weaker Canadian dollar.

The extent to which Canadian bond yields follow U.S. yields higher will be an important theme for 2017. Historically, domestic yields have followed U.S. yields even during periods when the Canadian economy did not justify any change. In bond trader parlance, Canada is a 'yield taker' country. Any change in Canadian yields relative to U.S. bonds will likely have a significant effect on the value of the domestic currency.

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