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The loonie was lower by half a cent against the greenback ahead of the Fed meeting Wednesday and, while falling oil prices aren't helping, bond markets are to blame.

The first chart below shows that two-year U.S. Treasury bond yields have been climbing in anticipation of the Federal Reserve increase in interest rates. At the same time, the yield on the two-year government of Canada bonds has been dropping because of falling economic growth expectations.

As a result the 'yield spread' – the difference in the yield of Canadian and U.S. bonds – has been rising. Canadian two year yields are now 45 basis points (0.45 per cent) lower than two year Treasuries. This is a huge change from November of 2013 when the government of Canada bond yield was 85 basis points * above * the equivalent U.S. bond.

Investor assets gravitate to higher yields and drive changes in currency values. Canadian bond investors in the current market, for instance, are incentivized to sell domestic bonds with lower yields, and buy U.S. bonds with higher annual income payments. This process depresses the value of the loonie. The proceeds from the sale of Canadian bonds are exchanged into U.S. dollars in foreign exchange markets to buy the Treasury bond.

The second chart shows the close connection between bond spreads and the value of the Canadian dollar. At the beginning of the chart, in November 2013, domestic bonds were yielding 85 basis points more than U.S. bonds and the loonie was $0.96. Now, with the domestic bond yields increasingly lower than U.S. bonds, the Canadian dollars is sliding.

The immediate future for the loonie price depends on what the Fed does and how bond markets react. A rate hike is likely to push Treasury yields higher to some degree (there are vehemently differing opinions on how much bond yields will move) and yield spreads are likely to increase. This would put further pressure on the value of the Canadian dollar.

The current large divergence in Canadian versus U.S. bond yields is reasonably rare. Historically , Canadian bond yields move in sympathy with U.S yields without respect to differences between the Canadian and U.S. economic outlooks. Canadians will be hoping that this time, domestic bond yields do not rise with Treasuries. This would increase domestic borrowing costs and threaten an already problematic outlook for domestic gross domestic product growth.

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