Loonie Going Negative to Bond Yields Means Poloz on Hold

Rising bond yields are coinciding with a falling currency for the first time in six years, aiding Canada’s shift from consumer to export-led growth and bolstering the case for the central bank to keep interest rates on hold.

The negative correlation between yields on Canada’s benchmark 10-year government bond and the currency reached 23 percent yesterday, the most since 2004, according to data compiled by Bloomberg. The 120-day rolling correlation first went negative June 21. The two had been positively correlated since February 2007, with that positive correlation reaching as high as 75 percent in 2010, meaning the Canadian dollar had a 75 percent probability of rising when bond yields rose.

With the global economic recovery picking up, foreigners are exiting Canadian debt at a record pace, sending borrowing costs higher, while speculation the Federal Reserve will slow monetary stimulus has caused the U.S. dollar to gain against most currencies, including Canada’s. The combination of rising borrowing costs and a falling currency are welcome developments for the Bank of Canada, which is looking to shift growth from consumers carrying record debt to exports.

“Some upward movement in bond yields, combined with the falling Canadian dollar, would help this transition to more export-led growth, which is something the Bank of Canada is not only forecasting but would find desirable,” Derek Burleton, deputy chief economist at Toronto-Dominion Bank, said by phone from Toronto. “It fits in with the story of a transition to more export-led growth.”

Fed Tapering

While Bank of Canada Governor Stephen Poloz has said he’ll keep interest rates on hold until signs of sustained economic growth, the Fed has signaled it will reduce stimulus this year. Speculation the U.S. central bank will slow its $85 billion a month of bond purchases as early as next month has sent yields up worldwide and reversed the flow of international capital into Canadian debt that’s lowered borrowing costs and supported the currency.

International investors looking for safety poured money into Canadian government bonds following the 2008 financial crisis, with 2009 seeing the largest international inflows on record, according to data compiled by Bloomberg.

Foreign holders sold a record C$19 billion ($18 billion) of Canadian bonds in June, Statistics Canada data released last week showed. That selloff pared the year-to-date purchases to C$16.1 billion, about half the pace foreigners were buying Canadian debt at the same time last year.

Yield Spreads

Elsewhere in credit markets, the Bank of Canada auctioned C$3.3 billion of two-year bonds at an average yield of 1.271 percent. The sale drew C$9.38 billion of bids, for a bid-to-cover ratio, a gauge of demand, of 2.84. The 1 percent debt matures in November 2015.

The extra yield investors demand to own the debt of Canadian investment-grade corporations rather than the federal government was unchanged yesterday from a day earlier at 121 basis points, or 1.21 percentage points, according to the Bank of America Merrill Lynch Canada Corporate Index. Yields rose to 3.31 percent, from 3.29 percent on Aug. 20.

Spreads on provincial bonds held steady at 73 basis points, according to Bank of America’s Canadian Provincial & Municipal Index. Yields increased to 3.15 percent, from 3.13 percent.

Federal-government bonds have lost 3.1 percent this year, Bank of America Merrill Lynch index data show. Provincial securities have dropped 4.2 percent, and corporate bonds have declined 0.8 percent.

Dollar Bets

The possibility the Fed will end its quantitative-easing stimulus program has been negative for Canada’s dollar. The central bank’s asset-buying has raised concern it would lead to inflation and risk debasing the U.S. currency. Investors are betting lower bond purchases will cause the U.S. dollar to strengthen against its Canadian peer.

The loonie, as the Canadian dollar is known for the image of the aquatic bird on the C$1 coin, has fallen from within a cent of parity in May to C$1.0501 per U.S. dollar at 9 a.m. in Toronto.

The Fed will slow its bond purchases at policy makers’ Sept. 17-18 meeting, according to 65 percent of economists surveyed by Bloomberg Aug. 9-13.

The Bank of Canada is not expected to raise its key rate until the end of 2014, according to the median estimate of an Aug. 8 Bloomberg economist survey with 23 responses. The benchmark has been held at 1 percent since September 2010. The central bank’s next interest-rate decision is Sept. 4.

‘Different Mix’

The Bank of Canada has cited a high Canadian dollar as an impediment to exports and record consumer-debt levels as the biggest threat to the Canadian economy. Bank Governor Poloz has said there are recent signs of a “constructive evolution” in household debt.

“I’m sure in the last few years they would have much preferred to see a slightly different mix, i.e., higher interest rates and a lower Canadian dollar, and in some ways market events are handing them that mix,” Doug Porter, chief economist at Bank of Montreal, said by phone from Toronto yesterday. “This trend may last a while, where the correlation starts to go the other way and higher yields do indeed go hand-in-hand with a weaker Canadian dollar.”

Canada’s 10-year government bond yield rose to 2.78 percent, the highest level since July 2011, and Canadian banks have raised their mortgage rates as yields increased.

Royal Bank of Canada boosted mortgage rates yesterday, its fourth increase since bond yields began to rise in May, after the Bank of Montreal raised its rates the day before, following similar moves by Toronto-Dominion Bank and Bank of Nova Scotia.

Currency Outlook

The rising rates, combined with government actions to tighten mortgage lending, have helped bring Canada’s ratio of debt to disposable income down from the record highs reached in September.

The Canadian dollar will fall to C$1.05 per U.S. dollar by the end of the year, according to the median estimate in a Bloomberg survey of 62 economists.

Canadian Imperial Bank of Commerce, the top forecaster for the loonie in the second quarter, sees it at C$1.06 by year-end, while second-place Toronto-Dominion Bank predicts it will weaken to C$1.09, estimates compiled by Bloomberg show.

Magna International Inc., North America’s largest auto-parts manufacturer, based in Aurora, Ontario, has not seen any benefit yet from the falling Canadian dollar but will if the trend continues, said Vince Galifi, the company’s chief financial officer.

“In terms of export sales, particularly to the United States more so than Europe, if there’s a view that the trend in the currency was longer-term and permanent, that could impact the behavior of our customers and where they make their purchases,” he said by phone from Aurora. “It’s a benefit to our Canadian plants exporting to the United States.”

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