It's no surprise that the Canadian dollar and two year government of Canada bond yields fell significantly and simultaneously after the Bank of Canada's statement on interest rate policy. The value of the loonie has been increasingly determined by the two year yield spread – the difference between domestic and U.S. two year bond yields – with crude prices more or less an afterthought.
The first chart below shows the extremely close relationship between the yield spread and the loonie. The reason the lines in the chart track so closely is because bond yields indicate cross-border cash flows. When Canadian bond yields are higher than U.S. yields, fixed income investment flows into Canada to take advantage of higher yields and income, which requires the exchange of foreign currency into Canadian dollars.
Rising bond yields can also indicate accelerating economic activity and inflation. In this case, foreign investors are more willing to invest in Canadian stocks, businesses or other assets and this also creates bids for loonies in foreign exchange markets.
A falling orange line on the chart indicates that domestic bond yields are falling relative to U.S. bond yields. Wednesday's Canadian dollar weakness is only the latest extension of a trend that began on Sept. 11 of this year when the government of Canada two year bond yield was 23 basis points higher than two year Treasury yields. The domestic yield is now 14 basis points below Treasuries.
The Bank of Canada statement cited a number of factors for the new more cautious stance on rate hikes, including the negative effects of the previously stronger loonie on exports, slow wage growth, and uncertainties regarding North American free-trade agreement negotiations.
The statement also made specific reference to notoriously high household debt levels: "Housing and consumption are forecast to slow in light of policy changes affecting housing markets and higher interest rates. Because of high debt levels, household spending is likely more sensitive to interest rates than in the past."
The consumer debt overhang makes economic forecasting – inflation, bond yields, GDP growth – even more of a crapshoot than usual. From private conversations with bank economists, I know they are well aware of the risks of rising debt levels.
The timing of when a household deleveraging process will begin in earnest however, with the corresponding negative effects on economic growth, is unpredictable. There is no shortage of anecdotal evidence that speculation is rampant in at least the Greater Toronto Area, but HSBC recently noted that the amount of aggregate Canadian mortgage payments in arrears is close to record lows.
Prominent economists are not about to forecast the day when large numbers of Canadian consumers decide to cut spending to repay debt. This is the same thought process that prevents equity portfolio managers from trying to call a market top.
Once the evidence of consumer financial stress builds – retail spending, bankruptcies and the like – estimates for inflation, growth, bond yields and the loonie will be slashed – but not until that point.
It's likely that bond markets, in the form of falling yields, will provide the earliest warning that Canada's credit-driven growth story is about to end. And since yields have been the main determinant of currency value, the loonie will drop at this stage also, and this will be the signal for investors to pull in their horns and reduce portfolio risk.