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The Canadian and U.S. economies are moving in opposite directions to a degree rarely seen – which is great news for the loonie but a dilemma for the Bank of Canada.

The Canadian economy is export-oriented, selling virtually everything we make and don’t use to the United States. These synergies keep the domestic growth rate roughly in line with the U.S. economy under normal conditions. But conditions, for the moment, are no longer normal.

The first accompanying chart compares the Citi Economic Surprise Index for Canada with that of the United States. Each benchmark compares actual economic data releases with consensus estimates. A reading of zero would indicate that economic reports were all coming in as expected.

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Since mid-November, 2018, the Canadian surprise index has surged higher, signalling that most of the important economic data points came in above estimates. The domestic index is now at its highest, most positive point in the past five years.

However, the U.S. index is plumbing new depths, threatening the five-year low set in June, 2017.

The pace of Canadian and U.S. economic growth affects inflation levels and by extension bond yields, and by further extension the value of each country’s currency. The link between economic growth and yields was clearly on display after Wednesday’s Fed meeting. Federal Reserve chairman Jerome Powell acknowledged slowing growth and signalled rate cuts ahead, sending U.S. bond yields and the greenback lower as a result.

Canadian and U.S. economies going

in completely different directions

Citi Economic Surprise Index-Canada

150

Citi Economic Surprise Index-U.S.

100

50

0

-50

-100

-150

2014

2015

2016

2017

2018

2019

Bond yields drive the Loonie’s value

Two-year Gov’t of Canada bond yield

minus two-year U.S. Treasury yield

CAD/USD

$1.00

0.8%

0.6

0.95

0.4

0.90

0.2

0.85

0.0

-0.2

0.80

-0.4

0.75

-0.6

0.70

-0.8

0.65

-1.0

2014

2015

2016

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

Canadian and U.S. economies going

in completely different directions

Citi Economic Surprise Index-Canada

150

Citi Economic Surprise Index-U.S.

100

50

0

-50

-100

-150

2014

2015

2016

2017

2018

2019

Bond yields drive the Loonie’s value

Two-year Gov’t of Canada bond yield

minus two-year U.S. Treasury yield

CAD/USD

$1.00

0.8%

0.6

0.95

0.4

0.90

0.2

0.85

0.0

-0.2

0.80

-0.4

0.75

-0.6

0.70

-0.8

0.65

-1.0

2014

2015

2016

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

Canadian and U.S. economies going

in completely different directions

150

Citi Economic Surprise Index-Canada

Citi Economic Surprise Index-U.S.

100

50

0

-50

-100

-150

2014

2015

2016

2017

2018

2019

Bond yields drive the Loonie’s value

Two-year Gov’t of Canada bond yield

minus two-year U.S. Treasury yield

CAD/USD

$1.00

0.8%

0.6

0.95

0.4

0.90

0.2

0.85

0.0

-0.2

0.80

-0.4

0.75

-0.6

0.70

-0.8

0.65

-1.0

2014

2015

2016

2017

2018

2019

JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg

The second chart shows the specific relationship between bond yields and the Canadian dollar. The value of the loonie has closely tracked the difference, or spread, between Canadian and U.S. two-year bond yields. Correlation calculations identify bond yields as a more powerful driver of the currency than oil prices over the past five years.

The orange spread line on the chart has been surging since April 24 of this year, indicating that Canadian bond yields are climbing relative to U.S. yields.

The trends in the first chart – domestic growth strengthening while the U.S. economy slows – support rising Canadian bond yields relative to U.S. Treasuries and a rising loonie.

The stronger Canadian dollar is great for cross-border shoppers but eventually it becomes hazardous for the domestic economy. An expensive loonie in U.S. dollar terms makes domestic goods less competitive in the United States and makes American-made products more attractive here.

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The most recent data point shoving the Canadian surprise index higher was the stronger-than-expected inflation reported on Wednesday. Merrill Lynch economist Carlos Capistran believes this ties the Bank of Canada’s hands for 2019. “We increase our forecast for [end-year inflation] to 2.2 per cent from 2.1 per cent. … We expect the Bank of Canada to maintain the overnight rate target on hold this year, even if the U.S. Federal Reserve cuts,” he said in a note published Thursday.

At 76 US cents, the Canadian dollar is likely not yet at a level that threatens the trade balance and economic growth. In the future, however, if upward inflation pressure remains – stalling rates cut by the Bank of Canada – and the loonie climbs significantly higher, this will become a risk.

For now, investors should expect a strengthening Canadian dollar and keep a close eye on export statistics.

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