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Economists’ predictions for domestic and U.S. bond yields paint a very bullish picture for the loonie in the second half of 2018, but there’s a problem – where Canada is concerned, the forecasts make little sense.

The accompanying chart underscores relative bond yields as the primary driver of the Canadian dollar’s value over the past five years (for reasons I detailed earlier this year). The blue line represents the two-year spread – the yield on the government of Canada two-year bond yield minus the yield on the two-year U.S. Treasury bond.

shifting expectations

$1.00

1.0%

CAD/USD (left scale)

Spread: 2Y Gov’t of Canada

0.8

0.95

bond yield minus

2Y U.S.Treasury yield (right)

0.6

0.90

0.4

0.85

0.2

0.80

0.0

-

0.2

0.75

-

0.4

0.70

-

0.6

0.65

-

0.8

-

0.60

1.0

2013

2014

2015

2016

2017

2018

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

shifting expectations

$1.00

1.0%

CAD/USD (left scale)

Spread: 2Y Gov’t of Canada

0.8

0.95

bond yield minus

2Y U.S.Treasury yield (right)

0.6

0.90

0.4

0.85

0.2

0.80

0.0

-

0.2

0.75

-

0.4

0.70

-

0.6

0.65

-

0.8

0.60

-

1.0

2013

2014

2015

2016

2017

2018

JOHN SOPINSKI/THE GLOBE AND MAIL

SOURCE: scott barlow; bloomberg

shifting expectations

$1.00

1.0%

CAD/USD (left scale)

Spread: 2Y Gov’t of Canada

0.8

0.95

bond yield minus

2Y U.S.Treasury yield (right)

0.6

0.90

0.4

0.85

0.2

0.80

0.0

-

0.2

0.75

-

0.4

0.70

-

0.6

0.65

-

0.8

0.60

-

1.0

2013

2014

2015

2016

2017

2018

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

The lines on the chart have tracked extremely closely over the past five years and this tight relationship is backed up by correlation calculations. When the yield on Canadian bonds falls relative to U.S. bonds, a declining blue line, the Canadian dollar has consistently dropped in value.

Currently, the loonie is trading at 75 U.S. cents and the two-year spread is minus 73 basis points or 0.73 per cent.

Bloomberg’s survey of economists predicts a 2.16-per-cent yield on domestic two-year bonds and a 2.76-per-cent yield on two-year U.S. Treasuries at the end of 2018. So at this point economists expect that Canadian bond yields will climb more than U.S. bonds in the second half of the year – the spread will narrow from minus 73 basis points now to minus 60 basis points (2.16 minus 2.76). This scenario would cause a significant jump in the blue line on the chart, and a rising loonie if current patterns persist.

It seems highly unlikely, however, that Canadian bond yields will rise more than U.S. bonds at this point. Weak domestic data announced Friday – retail sales and inflation came in well below expectations – indicated a flagging economy that would not support higher interest rates and yields.

Futures and options markets reacted swiftly to signs of a slowing Canadian economy. On June 8, derivative prices implied a 78 per cent chance that the Bank of Canada would raise interest rates (pushing bond yields higher) at its next meeting on July 11. After the data was released, the probability declined to 51 per cent, basically a coin toss.

A Bank of Canada more inclined to sit on the sidelines rather than raise rates throws a wrench into economist expectations for rising domestic bond yields, a narrowing yield spread to Treasuries, and a strengthening loonie.

As for the U.S., the Federal Reserve appears much more strident in its conviction to raise interest rates, a policy that would increase the bond spread and weaken the loonie. Ben Hunt, chief investment strategist at U.S.-based Salient Partners recently wrote that “[The Fed has] told us and told us that they’re going to keep raising rates. And they will.”

Canadian economists are well aware of the weakening data putting downward pressure on interest rates and yields, even if they haven’t yet cut their forecasts. I suspect they are waiting for more clarity on NAFTA negotiations and business sentiment before deciding how far to adjust expectations.

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