The loonie touched its weakest since July 5 at $1.3002.
The Bank of Canada sounded a cautionary note in its latest update on monetary policy and, if this translates into fewer interest-rate hikes, the effects will be visible in a weaker loonie.
Economists correctly predicted that the central bank would leave interest rates unchanged after the March 7 meeting on monetary policy. Governor Stephen Poloz highlighted two potential hurdles to economic growth as reasons not to hike: negotiations on the North American free-trade agreement and consumer credit growth.
The emphasis on NAFTA-related uncertainty concerns was expected, but the underscoring of credit and household indebtedness in the Bank of Canada's statement was relatively new, "the Bank continues to monitor the economy's sensitivity to higher interest rates. Notably, household credit growth has decelerated for three consecutive months."
Further deterioration in credit growth – while likely healthy for consumers in the longer term – would represent a significant headwind for a domestic economy that has been boosted by residential real estate markets and, like most of the developed world, is predominantly oriented to consumer services.
Central bank monetary policy affects currency values through bond yields, as the chart below depicts. The purple line (spreads) shows the relative yields on Canadian and U.S. bonds – the yield on the government of Canada two-year bond minus the yield on the two-year U.S. Treasury. A rising line indicates that domestic bond yields are climbing relative to their U.S. counterparts.
The value of the Canadian dollar has tracked this measure almost exactly over the past five years. There are a few reasons for this. One, higher Canadian yields motivate foreign investors to sell their local bond holdings, and exchange the funds into loonies to buy Canadian bonds to generate more income. Inflation expectations are also embedded into bond yields, so rising yields might also indicate that domestic economic growth is strengthening (generating inflation pressure) and that foreign investors attracted to Canadian businesses with growing profits are also creating demand for Canadian dollars in foreign exchange markets.
Since September, 2017, Canadian yields have been falling relative to U.S. yields (the purple line has been falling) and the loonie has been weak. This reflects strength in the U.S. economy and subsequent expectations for numerous Federal Reserve interest-rate increases.
The economic-growth-related concerns highlighted by the Bank of Canada last week raise the possibility that our central bank will be unable to keep pace with the Fed in terms of raising interest rates. This scenario would include even lower bond yields relative to the Americans, further drops in the blue line, and a significantly lower Canadian dollar.
Economists have yet to reduce their forecasts for Canadian bond yields, so a falling loonie is not a foregone conclusion at all. Positive developments in NAFTA negotiations, for instance, could remove market uncertainty and allow economic growth expectations to stabilize or improve. This would support higher bond yields.
While domestic economic insecurities remain, however, investors should not be surprised if news of slow domestic credit growth, or an increasing reluctance to raise rates by the Bank of Canada, are met with selling in the Canadian dollar.