Commodity prices are clearly a major driver of the Canadian dollar but yield spreads, the difference between Government of Canada and U.S. Treasury bonds yields, are playing a far larger role than most investors realize.
The accompanying top chart won't surprise too many investors. The value of Canadian dollar has closely tracked the Citi index tracking the prices of the commodities Canada exports most. Bluntly stated, the loonie's value tracks the amount of U.S. dollars exchanged into Canadian dollars to buy oil.
The surprise is that the relative yield of Canadian bonds appears to be an equally powerful force in determining the exchange rate for the loonie. The lower chart compares the loonie with the difference in yields between two-year Government of Canada bonds and U.S. Treasuries.
The red line on the lower chart shows the two-year spread – the yield on two-year Canada bonds minus the yield on two-year Treasury bonds. Not only does the spread follow the exchange rate closely, the correlation is actually slightly higher than the relationship between the loonie and commodity prices.
If yields are at least as important as commodity prices in determining the value of the Canadian dollar, this is bullish news. Two-year domestic bond yields are now almost equal to their American counterparts when on Feb. 20, Canadian two-years yielded 23 basis points less than Treasuries. At that point, yield-hungry bond investors were much more likely to ignore domestic issues and buy U.S. bonds.
The charts – showing the loonie roughly in-line with commodity prices and two-year yield differentials – suggest the domestic currency price should be stable as long as these markets remain close to current levels. Investors should follow both of these indicators for hints on future currency trends.
Scott Barlow, Globe Investor's in-house market strategist, writes exclusively for our subscribers at ROB Insight and Inside the Market online.