Goldman Sachs and Morgan Stanley both predict oil prices at $20 (U.S.) per barrel. Merrill Lynch economists predict the Bank of Canada will cut the benchmark interest rate by 25 basis points on Jan. 20. If this comes to pass, Canadians should prepare for a 67-cent loonie.
As the term "petroloonie" suggests, most investors are aware that the value of the Canadian dollar follows the price of oil. It's less well known that interest rates – specifically, the difference between Canadian and U.S. two-year government bond yields – play an even larger role in foreign-exchange markets than oil.
The first chart below shows how easily the fall of the loonie can be attributed to global bond markets. The red line tracks the loonie. The grey line represents the difference between Canadian and U.S. two-year government bond yields. This is calculated by simply subtracting the U.S. yield from the Canadian bond yield. The declining grey line on the chart indicates that domestic bond yields have been falling relative to U.S. yields.
Merrill Lynch economist Emanuella Enenajor published a research report Monday predicting that the Bank of Canada would cut the benchmark interest rates in half to 25 basis points later this month. This event would increase the yield spread – Canadian bond yields would fall while U.S. yields would remain the same – and it would put further downward pressure on the loonie. The chart projects into the future and estimates the potential change in the yield spread if the Bank of Canada cuts rates, and the likely course of the Canadian dollar as a result.
The two-year Canadian bond yield will not fall a full 25 basis points when Governor Stephen Poloz cuts the overnight rate. For the sake of illustration, I've assumed the domestic two-year yield will drop a hypothetical 12 basis points when the rate cut occurs.
The current two-year Canadian bond yield is 0.39 per cent and the U.S. Treasury yield is 0.93 per cent. This makes the current spread 0.54 per cent – the domestic bond yield is 54 basis points less than the U.S. yield. A further 12-basis-point decline on a Bank of Canada rate cut would increase the spread to 0.66 per cent or 66 basis points.
The relationship on the chart suggests that a 66-basis-point spread equates to a Canadian dollar in the 67-cent to 68-cent range.
West Texas intermediate crude prices at $20 would not help the loonie much either, as the second chart shows. The Canadian dollar has not tracked the oil price as closely as the yield spread over the past three years, but the relationship has gotten extremely close in recent months.
Again, I've extended the chart's time frame into the future to estimate the potential effects of a $20 oil price on the loonie. If oil falls that far, and the Canadian dollar falls in accordance with the historical relationship on the chart (i.e., the red line representing the Canadian dollar drops in accordance with the oil price), this suggest a loonie value in 67.5-cent range.
The 67 cents should be viewed as a rough estimate. It is based on current relationships between the domestic currency, bond markets and oil prices. Market correlations often change. Still, Canadians – particularly those headed south to Florida or Arizona for winter vacation – should be aware that all current signs point to a significantly lower loonie.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at Inside the Market online.