The recent strength in the Canadian dollar is widely attributed to stronger than expected domestic economic data but the three charts below suggest there's a lot more than that going on. In effect, the loonie is caught up in the same "Trump trade" dilemma as the rest of the world's major markets.
The first two charts support the idea that the domestic currency is caught in a tug-of-war between the two primary factors determining its value.
Correlation calculations show that relative bond yields – the two-year government of Canada bond yield minus the two-year U.S. Treasury yield – have been the largest driver of the Canadian dollar's value over the past two years. The strong relationship is illustrated in the first chart below.
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The second chart shows the effects of oil prices on the loonie, which are almost as strong as relative yields.
The key point to note in comparing the two charts is that the Canadian dollar is currently overvalued in terms of bond yields and undervalued relative to oil prices. This makes it very difficult to predict the short-term direction of the loonie's value in fixed-income markets – the two forces are pushing the currency in different directions.
The third chart below highlights what I believe is the most underrated factor underlying recent strength in the Canadian dollar – declining speculative bullishness on the greenback against which the loonie is valued. It's not that the Canadian dollar is strong, it's more that the greenback is weaker.
Investor bullishness on the U.S. dollar and U.S. assets had been building for months and, according to the Merrill Lynch global survey of fund managers released in January, "long U.S. dollar" remains the most crowded trade in the world. Now, as the trade becomes less popular, the greenback falls and the loonie rises (along other global currencies).
The weekly Commitment of Traders report from the Commodity Futures Trading Commission (CFTC) measures bullish futures positions for speculative investors, notably hedge funds. The chart shows that the net position on the U.S. dollar index – bullish futures minus bearish bets – spiked sharply upward in the lead up to and after the U.S. election. Since December, however, the speculative optimism has been proven misplaced, as the trade-weighted dollar index, which values the U.S. dollar against the currencies of all of its major trading partners, not just Canada, dropped more than 2 per cent.
The U.S. trade-weighted dollar index dipped more than half a percentage point Monday – a significant move for this benchmark – in a sign that post-election optimism is fading fast. (This latest dip is not shown on the chart because the CFTC data are produced weekly, on Fridays.)
This is the part of the column where I'm supposed to use all this data to predict the near-term course of the loonie, but there's no way I can do that. Not only would it require forecasting whether bond yields or the oil price will win the tug-of-war and take control over the domestic currency, it would also require a guess as to the effects of the latest random presidential utterance on the greenback.
One thing that is clear is that, by the end of 2016, U.S. dollar-related optimism was overdone and by extension, so was selling in the loonie. The recent trend of a stronger Canadian dollar and weaker greenback could merely be a healthy pause in a sustained U.S. dollar rally or, if global markets really lose confidence in the American political system and economy, the start of something new. There isn't, in my opinion, enough evidence to forecast either way right now.