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.
CADUSD vs WTI and two-year bond yield spread
Last three years
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
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.
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.
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