The Canadian dollar is ditching its close shadowing of yield spreads, clearing the way for other metrics to drive the currency, as interest rate hike cycles in North America become more established and investors bet on a weaker greenback.
The loonie has tended to closely track the gap in yield between Canada's 2-year bond and its US equivalent. But the currency and the yield spread have been heading in opposite directions since the beginning of the year. The weakened link could indicate that investors who bet on the direction of the Canadian dollar need to pay more attention to other catalysts for the currency, such as capital flows and oil prices.
"The two-year spread will become less important as the (rate hike) cycle becomes more predictable or as other drivers become more dominant," said Mark McCormick, North American head of FX Strategy at TD Securities. The link to yield spreads has also loosened for some other major currencies, such as the euro, after the US dollar broadly fell since November even as the Federal Reserve continued to raise interest rates.
But investors in the Canadian dollar had become used to a nearly perfectly positive correlation between the currency and spreads after the Bank of Canada raised interest rates three times since July, to leave the benchmark rate at 1.25 percent. The Canadian dollar has completely ignored the shift in yield spreads after having been "attached to the hip" in the second half of last year, said Shaun Osborne, chief currency strategist at Scotiabank.
His model estimates the fair value of the loonie at around C$1.2950, much weaker than the C$1.2300 level it was trading at on Thursday. "It rather suggests you are seeing a broader move out of US assets," Osborne said.
Investors are anticipating that global capital flows will shift in favor of currencies other than the greenback, should the European Central Bank and the Bank of Japan terminate massive bond buying programs, strategists said.