Is the loonie flying out front for a change? Investors and politicians alike are at a loss to explain the recent dive in the Canadian dollar. Perhaps that is because the answer lies in the political rather than the economic realm. And where the loonie leads, the bond and equity markets may soon follow.
As most Canadian policy makers are quick to note, the 12 per cent depreciation of the Canadian dollar since last summer cannot be explained by economic fundamentals alone. Most Canadian indicators have moved in lock-step with the U.S. Indeed, the Canadian economy has slightly outperformed the U.S. over the past year and inflation has slowed more in the U.S. than on this side of the border. Reflecting these similar trends, short-term interest rate spreads have narrowed by less than 20 basis points, a sure sign of investors' belief that the monetary policies of the Bank of Canada and the Federal Reserve are on a similar trajectory over the next couple of years. Canadian household leverage is exceedingly high, but the situation has not deteriorated over the past year.
So what explains the recent swoon in the loonie?
One reason comes to the fore: The possibility of Quebec separating from the rest of Canada. It has been more than two decades since the question of Quebec succession has been front-page news. However, the spring election in Quebec, in which the Parti Québécois is expected to win a majority, has reopened the issue.
International investors, now better schooled in the macroeconomic issues of separation thanks to the upcoming Scotland sovereignty vote, could well be taking a skeptical look at the next developed-market country likely to become embroiled in such a debate. Scotland and Quebec bear many similarities, including cultural distinctiveness compared to the rest of their country, and a wealth of natural resource – base commodities in the case of Canada and off-shore energy in Scotland.
With the sovereignty debate gaining momentum in Scotland ahead of the September vote and polls showing some possibility of success for the separatists, the currency markets could now be pricing in the possibility of a similar debate in Quebec. And since the investment view is forming outside of Canada rather than within, the currency market may be ahead of other financial markets, including bonds and equities, in discounting such a possibility.
A further escalation in the Quebec sovereignty debate would have several market implications, all boiling down to a rise in the risk premium, i.e. investors will start demanding higher rates of return to hold Canadian assets relative to their fundamental values.
First, the Canadian dollar could depreciate further and undershoot fair value. Most models place fair value at around 90 to 95 cents, but as Paul Krugman famously demonstrated decades ago, currencies always undershoot their fair-value target when speculators are involved.
Second, the spread between Canada and U.S. bonds could widen sharply. For the two decades that the separatist movement dominated the political debate from the mid-1970s to the mid-1990s, Canadian long-term bond yields commanded on average a 150-basis-point spread to the U.S., compared to a –50 basis-points spread today.
To be sure, there were other factors at play in driving interest-rate spreads as wide as they ultimately became. Net Federal debt climbed from 16 per cent of GDP in the mid-1970s to over 65 per cent in the mid-1990s, and there was a risk that those rates would shoot higher if Quebec separated but did not assume its share of the Federal debt. Shrinking the debt by raising taxes became no longer an option since the private sector was considered largely tapped out as taxes climbed to 16 per cent of GDP from 11 per cent in the mid-1980s. Moreover, as bond yields climbed and the yields curve steepened, the Federal government started to issue more and more short-term debt in order to minimize its debt service costs. By the mid-1990s almost half of federal debt outstanding was in the Treasury bill market, making the government incredibly vulnerable to even temporary spikes in interest rates.
So, while a return to the 1970s – and a 200-basis-point widening in long-term spreads – seems far-fetched at this point, particularly since opinion polls in Quebec do not indicate a majority support for separation. Nonetheless, investors should probably expect more weakness in the dollar and at least some widening in bond spreads.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.