Update to our Canadian dollar outlook

Loonie continues to fly high

We’ve been fielding a lot of questions on the Canadian dollar and the direction it may take from here. So, we thought it made sense to put together our quick thoughts.

As the loonie has rallied 5.6% against the U.S. dollar over the first five months of the year, and 20% since March 23, many are wondering if there’s anything left in the tank. While we agree that it has climbed rather quickly against the greenback, as always it’s important to look at the drivers behind the movement of the currency and what they tell us about the future direction.

After reaching our team’s upper bound target of US$0.81 from our Q1 2021 outlook, we revised our target for CADUSD higher to US$0.83, on higher sustained oil prices, at the end of March. Since then, however, it appears as if the Bank of Canada (BoC) might move ahead of the U.S. Federal Reserve in rate increases in the back half of 2022. This brings the two-year spread back into the fold as far as the direction of the CAD is concerned. Based on our fair value model, both rates and oil prices suggest continued upward pressure for the CAD with a target of US$0.84–0.85 over the next 6‒12 months.

Our team’s research suggests that there are not one but two main drivers of the CAD/USD exchange rate over time: oil prices, and the spread between the two-year Canadian Government bond yield and the two-year U.S. Treasury yield. Not surprisingly, when the price of oil, as measured by West Texas Intermediate (WTI), is moving higher, it exerts upward pressure on the Canadian dollar and vice versa.

The influence of the two-year yield differential relates to the differing monetary policies of the Bank of Canada and the U.S. Federal Reserve. When the two-year Canadian government bond yield is increasing faster or is greater than the two-year U.S. Treasury yield, it’s often a signal that the BoC is hawkish or likely to raise its benchmark overnight interest rates faster than the Fed. This narrowing or negative differential would be supportive of a stronger Canadian dollar, and when it widens or becomes more positive, it would be a headwind.

These two factors don’t always have a strong influence on the direction of the currency. Often, one is stronger than the other and sometimes one isn’t at all relevant. For example, since February of last year, the correlation between the Canadian dollar and the two-year yield differential has been between -0.5% and 0.5%. This level of correlation suggests that there wasn’t much impact. This shouldn’t be surprising as both central banks were committed to bringing their monetary policies close to the zero bound and were expected to keep them there into 2023. As a result, the two-year spread remained stagnant for much of the last year. More recently, however, this correlation has picked up to -0.65% while the correlation between the loonie and WTI has remained above 60%. This is a consequence of the expectation that the BoC may begin raising their interest rate sooner than the Fed, causing an increase in the two-year Canadian bond yield.

Three-month correlation
CADUSD vs WTI and two-year bond yield spread
Last three years

Here’s a chart that compares the three-month correlation between the Canadian and U.S. dollar exchange rate to the three-month correlation between the West Texas International oil price and the two-year bond yield spread, from 2018 to 2021.
Source: Manulife Investment Management, Bloomberg, as of May 31, 2021

Trying to time currency moves is always a challenge. However, our team’s regression model, using the price of oil and the two-year differential, can at least help us identify the potential direction.

Modeled CADUSD exchange rate vs Actual CADUSD exchange rate
2015 ‒ current

This chart compares the modeled Canadian and U.S. dollar exchange rate to the actual Canadian and U.S. dollar exchange rate, from 2015 to May 2021.
Source: Manulife Investment Management, Bloomberg, as of May 31, 2021

Currently, both the price of WTI at $67 and the two-year differential at -0.18%, suggests that the Canadian dollar is undervalued at US$0.83 and could trend toward US$0.85. While there’s likely less upside to the loonie from here, when looking at the driving factors of the currency movement over time, it’s clear that the balance of risks is weighed to the upside, not down.

Kevin Headland
Senior Investment Strategist
Manulife Investment Management

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

The opinions expressed are those of Manulife Investment Management as of the date of this publication, and are subject to change based on market and other conditions. The information and/or analysis contained in this material have been compiled or arrived at from sources believed to be reliable but Manulife Investment Management does not make any representation as to their accuracy, correctness, usefulness or completeness and does not accept liability for any loss arising from the use hereof or the information and/or analysis contained herein. Manulife Investment Management disclaims any responsibility to update such information. Neither Manulife Investment Management or its affiliates, nor any of their directors, officers or employees shall assume any liability or responsibility for any direct or indirect loss or damage or any other consequence of any person acting or not acting in reliance on the information contained herein.

All overviews and commentary are intended to be general in nature and for current interest. While helpful, these overviews are no substitute for professional tax, investment or legal advice. Clients should seek professional advice for their particular situation. Neither Manulife, Manulife Investment Management Limited, Manulife Investment Management, nor any of their affiliates or representatives is providing tax, investment or legal advice. Past performance does not guarantee future results. This material was prepared solely for informational purposes, does not constitute an offer or an invitation by or on behalf of Manulife Investment Management to any person to buy or sell any security and is no indication of trading intent in any fund or account managed by Manulife Investment Management. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Unless otherwise specified, all data is sourced from Manulife Investment Management.

Manulife, Manulife Investment Management, the Stylized M Design, and Manulife Investment Management & Stylized M Design are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.

Kevin Headland

Kevin Headland, 

Senior Investment Strategist

Manulife Investment Management

Read bio
Macan Nia

Macan Nia, 

Senior Investment Strategist

Manulife Investment Management

Read bio
Philip Petursson

Philip Petursson, 

Chief Investment Strategist and Head of Capital Markets Research

Manulife Investment Management

Read bio