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Why a strong U.S. dollar could hurt Canadian bank stocks

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Traditionally, the automotive and resource sectors have been the ones most affected by Canadian dollar exchange rates. Since 2010, however, it has been bank stocks and Canadian government bonds that have moved most in accordance with the loonie, and may have the most to lose if the greenback continues to rise.

A comparison of the Canadian/U.S. dollar exchange rate against 22 industry-focused S&P/TSX sub-indices revealed that banks and diversified financial stocks have been the most correlated to the domestic currency. We expected energy and materials stocks would be the most sensitive to U.S. dollar fluctuations – a lower dollar implies higher commodity prices – but this was not the case.

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The link between banks and the loonie was not clear until a quick check on Canadian bond markets found that since 2000, there has been an 0.82 correlation between the Canadian dollar and government of Canada bond yields. Not only that, but changes in currency values were actually leading changes in bond yields. ( See this chart. )

Here's how we think the relationship is working. Before 2008, a falling U.S. dollar was causing an increased interest in Canadian dollar-denominated assets, which led to buying of Canadian government bonds, and this pushed those bonds' yields down. In turn, those yields lowered the cost of financing for the major banks, which made the banks more profitable, and increased their stock values.

There is no guarantee that the U.S. dollar will continue to stay strong. If it does, we would expect a reversal of the process described above – higher Canadian government bond yields (caused by numerous factors, including but not limited to this currency relationship) and downward pressure on profits for the major domestic banks.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here for more of his Insights, and follow Scott on Twitter at @SBarlow_ROB .

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