Professional traders use the term "whipsawed" to describe an asset that moves consistently in one direction, then abruptly changes course once everyone's placed their investment bets on the trend continuing, then changes back to its original direction.
Traders hate being whipsawed.
The loonie whipsawed traders by falling hard on Tuesday after comments from a prominent Federal Reserve president, climbing sharply early Wednesday by a half a cent after the positive report on Canadian exports, and then falling back again two hours later. I wouldn't want to be a currency trader, but it's now clearly exciting times for the Canadian dollar.
The process began Tuesday with a Wall Street Journal interview with Dennis Lockhart, president of the Federal Reserve Bank of Atlanta. Mr. Lockhart, viewed as a moderate member of the Fed, strongly suggested that the world's most important central bank was poised to raise interest rates in September.
Immediately after Mr. Lockhart's interview, the two-year U.S. Treasury bond yield jumped seven basis points to 0.73 per cent (a significant increase in percentage terms) while the Canadian two-year yield was largely unchanged. For the loonie, the difference in U.S. and Canadian bond yields is all-important – the more the U.S. yield rises above the level of the domestic bond yield, the lower the Canadian dollar goes.
The chart below shows the importance of the two-year yield differential in determining the value of the loonie. I used a year-to-date chart to better show recent market activity, but longer time frames actually make a more compelling case for the close connection between yields and the dollar.
The grey line is simply the Canadian two-year bond yield minus the two year U.S. Treasury yield. Near the end of the chart, the sharp move lower shows what happened after Mr. Lockhart's speech – U.S. yields went up, Canada's barely moved, and the yield differential increased, pushing the loonie lower.
Early Wednesday morning, the Canadian dollar jumped exactly half of a cent against the U.S. dollar after a Statistics Canada report showed stronger than expected export growth for June. But, by 9 a.m. ET the gains were largely erased. Thus, the loonie dropped significantly on Tuesday, jumped Wednesday morning, and then moved back the other way – a textbook whipsaw.
The lesson for Canadians in my opinion is that where the value of the loonie is concerned, U.S. bond markets are too powerful a force to fight with individual domestic equity reports. The domestic currency is unlikely to recover in value until Government of Canada bond yields increase enough to compete with U.S. Treasuries.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market.