Hawkish or dovish, comments from the Federal Reserve are likely to be the primary driver of the loonie's value in the coming weeks.
The minutes of the most recent FOMC meeting, released May 18, stunned markets with its hawkish tone. The increase in the likelihood of a central bank rate hike exacerbated a move higher in U.S. bond yields that was already underway, and this had significant ramifications for global currencies, including the loonie. (Separately, Tuesday's U.S. data showing a surge in new single-family home sales in April added further fuel to rate-hike speculation.)
The top chart (see below) shows the aggregate economist estimate on Federal Reserve interest rate hikes. The current Fed funds rate target range is between 25 and 50 basis points (0.25 to 0.50 per cent) after December's increase in rates. The 2016 portion of the chart represents the consensus view on another hike before the end of June.
Before the release of the Fed minutes, only 4 per cent of economists expected a June hike. Afterward, this number jumped almost immediately to 32 per cent. The consensus now appears to be that the Fed will raise interest rates in either June or July – 56 per cent of economists forecast that the Fed fund rate will be higher by the end of July. (not shown).
Central bank rates drive short-term bond yields – as the Fed hikes rates, bond yields follow – and relative bond yields have been the main force behind changes in currency values. The lower chart shows the importance of U.S. bond yield changes on the loonie. The orange line measures the difference between the yield on the Canadian two-year government bond and the U.S. bond yield (by simply taking the Canadian yield and subtracting the U.S. yield).
The value of the domestic currency has almost exactly followed changes in relative yields. The mathematical correlation between the two lines is extremely high – considerably higher than the correlation between the loonie and the oil price (not shown).
The more the Federal Reserve signals that a rate hike is imminent, the farther the loonie is likely to fall. Hawkish noises from Fed members should push U.S. short-term bond yields up, which increases the difference or "spread" between Canadian and U.S. yields. As the chart shows, the loonie has been falling to the extent that U.S. yields exceed Canadian yields.
It's possible, but not preferable, that short-term Canadian bond yields rise the same amount as U.S. yields. This would keep the spread the same, and the loonie's value would remain more stable. But higher domestic yields could also threaten the domestic economy by making credit more expensive when many economists believe Canadian gross domestic product growth will be negative for the second quarter of 2016.