Canadian one dollar coins at the Royal Canadian Mint in Winnipeg on July 5, 2013.Brent Lewin/bloomberg
The loonie is treading uncharted waters to some extent, still driven primarily by bond yields and central bank monetary policy but almost completely ignoring energy prices. Canadians looking to judge the next move for the dollar should watch U.S. Federal Reserve chairman Jerome Powell.
For most of the postcrisis time frame, the value of the Canadian dollar was easily understandable in terms of bond spreads – specifically the yield on the two-year government of Canada bond minus the yield on the equivalent U.S. Treasury bill.
The trend arose in large part as part of the global desperation for income. When domestic bond yields were higher than U.S. yields, as they were in 2013, foreign investment assets flowed into Canadian fixed income, creating a stronger bid and higher values for the loonie in currency markets. More recently, the reverse has been true as our dollar has been weaker against the greenback after domestic bond yields fell below U.S. yields in 2015.
The first accompanying chart shows how the relationship between the bond spread (blue line) and the loonie have weakened. From mid-2016 to October, 2017, the two lines in the chart move closely together, indicating a high degree of correlation.
Awaiting clarity on U.S. rate cut(s)
CAD/USD
2-yr spread: 2-yr Gov’t of Canada bond
yield minus 2-yr U.S. Treasury yield
$0.84
0.4%
0.82
0.2
0.80
0.0
0.78
-0.2
0.76
-0.4
0.74
-0.6
0.72
-0.8
0.70
0.68
-1.0
2016
2017
2018
2019
CAD/USD
WTI crude (US$, bbl)
$0.84
$90
0.82
80
0.80
70
0.78
60
0.76
50
0.74
40
0.72
30
0.70
20
0.68
10
0.66
0
2016
2017
2018
2019
john sopinski/the globe and mail
source: scott barlow; bloomberg
Awaiting clarity on U.S. rate cut(s)
CAD/USD
2-yr spread: 2-yr Gov’t of Canada bond
yield minus 2-yr U.S. Treasury yield
$0.84
0.4%
0.82
0.2
0.80
0.0
0.78
-0.2
0.76
-0.4
0.74
-0.6
0.72
-0.8
0.70
0.68
-1.0
2016
2017
2018
2019
CAD/USD
WTI crude (US$, bbl)
$0.84
$90
0.82
80
0.80
70
0.78
60
0.76
50
0.74
40
0.72
30
0.70
20
0.68
10
0.66
0
2016
2017
2018
2019
john sopinski/the globe and mail
source: scott barlow; bloomberg
Awaiting clarity on U.S. rate cut(s)
CAD/USD
Two-year spread: two-year Gov’t of Canada
bond yield minus two-year U.S. Treasury yield
$0.84
0.4%
0.82
0.2
0.80
0.0
0.78
-0.2
0.76
-0.4
0.74
-0.6
0.72
-0.8
0.70
0.68
-1.0
2016
2017
2018
2019
CAD/USD
WTI crude (US$, bbl)
$0.84
$90
0.82
80
0.80
70
0.78
60
0.76
50
0.74
40
0.72
30
0.70
20
0.68
10
0.66
0
2016
2017
2018
2019
john sopinski/the globe and mail, source: scott barlow; bloomberg
Since that point, the two lines have moved in a similar direction, but the connection is not nearly as close.
Short-term bond yields are affected greatly by central bank policy. I believe the Fed’s attempts to tighten monetary policy through most of 2018 – which caused an increase in U.S. yields relative to Canadian bonds and weakened the loonie – and then the Fed’s about-face to an easing bias in late December caused enough market confusion to weaken the correlation between spreads and the loonie even further.
It certainly hasn’t been oil prices driving the Canadian dollar as the second chart highlights. Historically the loonie has followed oil prices for similar reasons to the bond market asset flows description above. When crude prices rise, more U.S. dollars flow in to Canada to buy oil, and the conversion of those funds into loonies by Canadian energy producers pushes the domestic dollar higher in currency markets.
Over the past three years, the relationship between oil prices and the Canadian dollar has all but disappeared. I used West Texas Intermediate crude here because the correlation between the dollar and the Western Canadian Select oil (not shown) is even lower.
Where the loonie goes from here depends almost entirely on the Fed’s Mr. Powell. According to Bloomberg calculations, derivatives markets indicate a 60 per cent chance of two U.S. rate cuts before the end of October. This implies that one cut is a near certainty but there’s investor ambivalence about whether more easing is imminent.
Clarity on this question will move the U.S. bond market. If we keep in mind the market is partly pricing in two rate cuts, a single rate cut would likely result in U.S. bond yields moving higher than they are now. This would increase the two-year yield spread and the loonie would fall. Alternatively, two rate cuts would push U.S. yields lower relative to Canadian yields, and the Canadian dollar would likely rally.
As for domestic monetary policy, only one rate cut is expected from the Bank of Canada before Oct. 31, and this event is unlikely to change the yield spread significantly.
I’m not about to guess what the Fed will do so I can’t predict the short term course for the loonie. Mr. Powell and the Federal Open Market Committee must assess numerous factors before making their decisions – the severity and potential length of the U.S.-China trade dispute, the effects of a slowing global economy and random social-media proclamations from the White House to name three – and there’s too much confusion to assess the odds with any certainty.
Once investors have more certainty on the “one cut or two” interest rate question, the loonie’s course should be clear – higher if two Fed cuts, lower if only one.
Scott Barlow