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Two weeks ago the loonie looked hugely overvalued relative to bond yields and undervalued relative to oil prices. These divergences have now been largely corrected, but the weird part is that these two primary drivers of the currency are lagging the Canadian dollar's traded value: In normal circumstances, bond yields and oil move first and the loonie follows, yet now it appears the order has been reversed.

Relative bond yields and oil prices are the two most powerful forces determining changes in the loonie's price. In different ways, both indicate changes in money flows into the country. A higher oil price means more American dollars sold and exchanged into Canadian currency to purchase our oil. Higher domestic bond yields relative to U.S. yields means more foreign investors buying Canadian bonds to take advantage of rising dividend income.

The top accompanying chart tracks the dollar against relative bond yields – the Canadian two-year bond yield minus the yield on the two-year U.S. Treasury bond. At the beginning of June, the loonie looked significantly overvalued as the purple line was well above the grey line.

Stronger than expected domestic gross domestic product data pushed Canadian bond yields higher while U.S. yields drifted lower. This helped close the gap between the yield spread and the loonie on the chart, implying that the dollar is now more fairly valued.

The lower chart compares the value of the currency against oil prices. In this case, the loonie was undervalued versus crude at the end of May. The combination of falling oil prices and a rising currency now sees the loonie fairly valued relative to oil prices.

In both instances, the dollar was following its own path rather than being driven by yields or oil, and it was the bond and commodity markets that moved toward where the loonie was already trading. This is backwards to how things generally work – and likely a fluke – but it likely reflects the loonie was finding some middle ground between the downward pull of relative yields and upward pressure from oil.

The diverging paths of Canadian and U.S. economic data suggest that bond yields will be the dominant force affecting the Canadian dollar in the weeks ahead. Domestically, employment and housing data released this month highlight an economy that, if not yet firing on all cylinders, is still recovering far more quickly than expected. This pushed two-year Canadian bond yields upward from 72 basis points on June 8 to 86 basis points on Wednesday.

The U.S. economic trend is also surprising, but to the downside. On Wednesday, both U.S. retail sales and inflation reports came in much weaker than economists predicted. The U.S. Federal Reserve rate hike announced on Wednesday is protecting shorter-term U.S. yields from falling significantly so far, but a continuation in the data trend would push yields lower relative to Canadian bond yields and support a higher loonie.

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