Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.
The Federal Reserve is almost certain to raise interest rates Wednesday at 2 p.m. (ET), in a move that has significant downside risks for the Canadian dollar.
Currently, the loonie’s value is caught between the negative effects of relative bond yields and the positive influence of rising oil prices. But with transportation issues preventing a significant portion of domestic crude production from reaching U.S. markets, rising U.S. bond yields as the result of Federal Reserve rate hikes could serve to push the Canadian dollar lower.
The two accompanying charts highlight the influence of relative bond yields – the yield on the two-year government of Canada bond minus the yield on the comparable U.S. Treasury bond – and oil prices on the loonie. The top chart shows the extraordinarily close relationship (backed up by correlation calculations) between relative bond yields and the Canadian dollar. The lower chart shows the strong connection between oil prices and the loonie, although it hasn’t been as strong as the relationship with bond yields.
There are reasons for these tight relationships.
In a real sense, bond yields and crude prices are parts of the overriding equation that completely explains currency moves – the extent of foreign inflows of capital.
In the case of bond yields, when Canadian yields rise relative to U.S. yields, this attracts offshore fixed-income investments as portfolio managers sell some of their U.S. bond holdings and buy domestic bonds to increase annual portfolio income. (Higher bond yields also indicate higher inflation and economic growth, which motivates rising foreign investment in profitable Canadian companies). For oil, higher commodity prices mean more cash is imported into the country for every barrel sold.
Each foreign investor must first exchange their own currency into loonies to purchase Canadian assets, and this creates a upward move in the domestic currency in foreign exchange markets.
Currently, the loonie is overvalued relative to bond yields and undervalued in comparison with West Texas Intermediate crude prices.
The Bank of Canada and the Federal Reserve are in the midst of a monetary tightening cycle in the form of a deliberate series of interest rate hikes. Each rate increase puts upward pressure on two-year bond yields in the respective countries, so any differences in the pace of tightening between the United States and Canada will affect relative bond yields and the loonie.
Bloomberg calculates a 97-per-cent probability of a hike based on futures and options markets. This high degree of conviction suggests that the rate raise is already reflected in bond prices and an immediate sharp drop in the loonie after the announcement is unlikely. A move lower in the domestic currency is possible, however, if the statement accompanying the rate hike is more hawkish regarding future rates than the market expected.
The dollar will move lower on any signs that U.S. rates and bond yields will rise faster than domestic rates and yields. “We still believe the Bank of Canada will hike at a slower pace than the Fed, with growth rates in Canada to slow,“ Sam Bonney, London-based foreign exchange strategist for Nomura Securities International, said in a Sept. 24 research report. He further warned that “a lot of positivity" has already been priced into the loonie, despite stalled talks on the North American free-trade agreement. Mr. Bonney is recommending a short position on our dollar versus the Australian dollar.
The loonie has been supported by higher U.S. crude prices, but transportation logistics have blunted the actual positive effects on the currency. Crude by rail has only partly compensated for a lack of pipeline capacity and thus less oil is reaching markets.
The transportation bottleneck is evident in the steep discount at which Western Canadian Select oil trades relative to U.S. crude, which reached record levels Tuesday, according to a Reuters report. As a result, fewer U.S. dollars are being exchanged into Canadian dollars to buy oil.
With oil’s influence on the loonie fading, it will be central banks and bond markets that determine the future course of the currency.
tight relationships
CADUSD (left)
Two-year spread: Gov’t of Canada two-year
bond yield minus two-year U.S.
Treasury yield (right)
$1.10
1.5%
1.05
1.0
1.00
0.95
0.5
0.90
0.85
0.0
0.80
0.75
-0.5
0.70
0.65
-1.0
Sept. 26
2010
Sept. 26
2014
Sept. 21
2018
CADUSD (left)
WTI Crude US$/bbl (right)
$1.10
$120
1.05
100
1.00
0.95
80
0.90
0.85
60
0.80
40
0.75
0.70
20
0.65
0.60
0
Sept. 26
2010
Sept. 26
2014
Sept. 21
2018
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: scott barlow; bloomberg
tight relationships
CADUSD (left)
Two-year spread: Gov’t of Canada two-year
bond yield minus two-year U.S. Treasury yield (right)
$1.10
1.5%
1.05
1.0
1.00
0.95
0.5
0.90
0.85
0.0
0.80
0.75
-0.5
0.70
0.65
-1.0
Sept. 26
2008
Sept. 26
2010
Sept. 26
2012
Sept. 26
2014
Sept. 26
2016
Sept. 21
2018
CADUSD (left)
WTI Crude US$/bbl (right)
$1.10
$120
1.05
100
1.00
0.95
80
0.90
0.85
60
0.80
40
0.75
0.70
20
0.65
0.60
0
Sept. 26
2008
Sept. 26
2010
Sept. 26
2012
Sept. 26
2014
Sept. 26
2016
Sept. 21
2018
JOHN SOPINSKI/THE GLOBE AND MAIL
SOURCE: scott barlow; bloomberg
tight relationships
CADUSD
Two-year spread: Gov’t of Canada two-year
bond yield minus two-year U.S. Treasury yield
$1.10
1.5%
1.05
1.0
1.00
0.95
0.5
0.90
0.85
0.0
0.80
0.75
-0.5
0.70
0.65
-1.0
Sept. 26
2008
Sept. 26
2010
Sept. 26
2012
Sept. 26
2014
Sept. 26
2016
Sept. 21
2018
CADUSD
WTI Crude US$/bbl
$1.10
$120
1.05
100
1.00
0.95
80
0.90
0.85
60
0.80
40
0.75
0.70
20
0.65
0.60
0
Sept. 26
2008
Sept. 26
2010
Sept. 26
2012
Sept. 26
2014
Sept. 26
2016
Sept. 21
2018
JOHN SOPINSKI/THE GLOBE AND MAIL, SOURCE: scott barlow; bloomberg
Scott Barlow