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scott barlow

Globe and Mail columnist Scott Barlow.The Globe and Mail

CIBC called the loonie a 'risky bet' in a Friday report written by the economics and strategy teams.

The report also identified a new driver of the exchange rate – the CBOE Volatility Index. Based on their analysis, Canadian investors should expect a volatile, weaker loonie for the remainder of 2016.

I still maintain that relative bond yields are the main determinant of the Canadian dollar's value relative to the greenback (with the oil price a close second). But the loonie is viewed as a 'risk currency' by global portfolio managers and as CIBC points out, global market volatility historically causes the domestic currency to decline.

The CIBC strategists calculate that the trailing 120-day correlation between the loonie and the VIX has been climbing throughout 2016. As the first chart below shows, the loonie's inverse relationship with the VIX is an on again/off again thing over the past five years. But starting in January of 2015, the connection became much tighter and predictable. As one line on the chart climbed, the other fell.

The influence of "risk off' market sentiment as reflected in the VIX index might explain the divergence in the second chart.

The bond yield spread between Canadian and U.S. bonds – the yield on the domestic two-year government bond minus the yield on the two-year U.S. Treasury yield - has been the most reliable, consistent driver of the loonie's value in recent years.

In mid-January 2016, the loonie bottomed at 0.69 cents (U.S.). At the time, the two-year Canadian bond yield was almost 60 basis points lower than the U.S. yield. Investors on both sides of the border were selling Canadian dollar bonds to buy U.S. bonds in order to benefit from the higher yield.

The loonie staged a recovery as the Federal Reserve backed off on rate hike intentions. U.S. bonds yields fell to levels closer to Canadian yields, the spread narrowed from January's 60 basis points to the current nine basis points.

Since the U.K. referendum, Canadian yields have improved further versus U.S. bond yields but the loonie has failed to rally in response (that's what has created the divergence at the very end of the chart.)

CIBC's contention that post-Brexit risk aversion and the VIX index are the reasons the loonie has not rallied with yield spreads is almost certainly correct. And, with U.K. leadership changes delayed and negotiations with the European Union expected to drag on for years, the research team's loonie-related warning should be heeded,

"As uncertainty surrounding Brexit lingers, that pressure on the currency is unlikely to fully abate any time soon. The Canadian economy won't be providing much support for the loonie in the near term either. As data on the second quarter rolls in and the effects of the Alberta wildfires are quantified, the economy will prove to have been weaker during the period than markets currently expect. "