Why it's too early to call a bottom for the loonie

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The rally in the Canadian dollar is far more attributable to U.S. growth fears than the oil price or any economic developments in Canada. Renewed economic confidence south of the border – if it happens – would send the loonie skittering lower again. For this reason, it's too early to call a bottom in the loonie for 2016.

The oil price has been an excellent leading indicator for the value of our dollar in recent years but even so, the bond market has provided a better one. The difference in yield between U.S. and Canadian two-year government bonds has more closely followed changes in the value of the loonie than the oil price. More importantly, yields have become the far better indicator during the loonie's recent rally.

The accompanying two charts show the path of the Canadian dollar versus West Texas intermediate crude and the bond yield spread respectively. In both cases, the relationship is close (although for the record, correlation math puts the yield spread as slightly closer for the entire period).

The very end of each chart, covering the loonie's recent 7 per cent rally against the U.S. dollar, is telling. The Canadian dollar's rally has far outstripped strength in the oil price – the lines in the first chart have diverged somewhat – but the loonie's value and the yield spread remain closely tied. This implies that bond yields have been the bigger driver of the rally.

As I've discussed previously, relative bond yields are an important determinant of currency values. Investment assets will gravitate toward higher yields to capture larger income streams. At the end of 2015, for example, the yield on the two-year U.S. Treasury bond was 1.05 per cent, more than double the 0.48 per cent yield on two-year Canada bonds (a spread of minus 0.57 percentage points). Portfolio managers in Canada and across the globe had good reason to buy Treasuries because of the higher yield. This helped drive the U.S. dollar higher.

In 2016, however, the most important trend in global markets has been increased fears regarding a slowdown in U.S. economic growth. U.S. and global investors have been selling U.S. equities in large numbers and shifting assets into the relative haven of U.S fixed income. This process has driven U.S. bond yields lower and, as a result, the two-year U.S. Treasury yield has fallen back to 0.72 per cent. The yield on the Canadian bond yield has been largely stable at around 0.4 per cent for the year. The yield advantage enjoyed by Treasuries has shrunk by more than half, and the U.S. dollar has weakened against the loonie at the same time.

This analysis strongly implies that the loonie's future course will be determined by U.S. bond markets. If American growth fears persist, and Treasury yields continue to head lower relative to government of Canada bond yields, the Canadian dollar can be expected to rally further.

The inverse case is also true. Stronger U.S. economic data would likely see investment assets move out of bonds and into S&P 500 stocks, causing Treasury yields to rise. In this case, the loonie will resume its previous path lower.

There is also a sense in which Canadians might be happy to see the rally in the domestic currency end. In a post-commodity supercycle world, Canada's economic recovery depends on non-resource exports to the United States. The weaker U.S. economic data that is causing lower bond yields and a higher loonie, also means that U.S. demand for foreign goods is falling, and threatens this recovery.