Canada Dollar Declines 2nd Week on Diverging Central-Bank Policy

Canada’s dollar weakened for a second week on bets the New Year will see monetary policy diverge further as the U.S. Federal Reserve winds down monetary stimulus while the Bank of Canada stays on hold.

The currency fell against most major peers with Bank of Canada Governor Stephen Poloz signaling the benchmark interest rate will stay at 1 percent until the inflation rate picks up. The Fed will reduce the $85 billion in monthly bond purchases its uses to keep interest rates low by $10 billion in January, and economists forecast a halt to the program by year-end 2014.

“Further Canadian dollar weakness resumes in the New Year,” said Brad Schruder, director of foreign exchange at Bank of Montreal, by phone from Toronto. “Everything that you expected to happen with regard to the loonie weakening has taken place. The Federal Reserve has started their tapering program, you’ve seen the Bank of Canada come out with dovish sentiment, you’ve seen strong U.S. economic data.”

The loonie, as the Canadian dollar is known for the image of the aquatic bird on the C$1 coin, fell 0.7 percent to C$1.0706 this week. One loonie buys 93.41 U.S. cents.

Canada’s currency is down 0.9 in December, 3.7 percent in the fourth quarter and 7.3 percent this year, for its biggest annual loss since 2008.

Yield Spread

The loonie dropped against its U.S. peer as the extra interest available in U.S. 10-year government debt compared with Canadian equivalents, a measure of relative growth expectations, touched the widest since December 2010.

The yield advantage of 10-year U.S. Treasuries increased to 27 basis points, or 0.27 percentage, more than equivalent maturity Canadian government debt, on Dec. 26. The interest rate advantage makes U.S. securities more attractive than Canadian ones, contributing to currency weakness.

That gap narrowed yesterday as Canadian 10-year yields posted their biggest one-day increase in almost a month, rising six basis points, or 0.06 percentage point, to 2.78 percent. Yields dropped 11 basis points on the week. The 1.5 percent security maturing in June 2023 lost 81 cents to C$89.49.

The benchmark U.S. 10-year note yield climbed yesterday to the highest level in two years, touching 3.02 percent.

“There’s just so much positive momentum with the American economy right now and very little positive support for the loonie,” said BMO’s Schruder. “The loonie is sputtering and the U.S. dollar is a race car.”

Oil Gains

The loonie declined this week despite gains in crude oil, Canada’s largest export. Futures on crude oil increased 0.8 percent to $100.15 per barrel and touched $100.75, a two-month high, and have gained 9.1 percent this year.

The 120-day correlation coefficient between the Canadian dollar and crude-oil futures fell to 0.12 yesterday, the lowest since October 2007. Its high this year is 0.47 on June 21. A reading of 1 indicates the measures move in lockstep, zero means no correlation at all.

The cost to insure against declines in the loonie versus its U.S. peer fell to the lowest in almost nine months, with the three-month 25-delta risk-reversal rate dropping to 0.92 percent on a closing basis, the lowest since April. The average this year is 1.25 percent. Risk reversals measure the premium on options contracts to sell Canadian dollars versus buying U.S. contracts that do the opposite.

Central Banks

Bank of Canada Governor Stephen Poloz said in a Dec. 17 interview that inflation has been lower than policy makers can explain, which helped lead him to surprise investors in October by dropping a bias to raise interest rates. The central bank will probably keep its policy rate at 1 percent through next year, economists forecast, extending the longest such pause since the 1950s.

“The message from Poloz -- which has been about a slower recovery, not quite as hawkish a view on the currency -- that’s allowed the Canadian dollar to lose 5 cents or more,” Don Mikolich, executive director of foreign-exchange sales at Canadian Imperial Bank of Commerce, said by phone from Toronto. “It’s thought the Bank of Canada will be less in a hurry to raise interest rates and be less of an attractive commodity than the U.S. dollar.”

The greenback has gained 0.9 percent on the loonie since the Fed said on Dec. 18 it plans to cut monthly asset purchases in January to $75 billion from $85 billion. Policy makers will probably reduce bond purchases in $10 billion increments over the next seven meetings before ending the program in December 2014, economists said in a Bloomberg survey on Dec. 19.

‘Robust’ Recovery

The loonie will decline to C$1.08 by the end of 2014, according to the median estimate of economists in a Bloomberg survey.

“CAD weakens over the next six to eight months,” said Camilla Sutton, head of currency strategy at Bank of Nova Scotia, in a phone from Toronto Dec. 24. “What we get is broad-based U.S. dollar strength just on the back of the recovery that is relatively robust, as well as speculation as when tapering occurs and whether it’s a steady pace or a little bit more aggressive than that.”

The loonie has declined 4.5 percent this year against nine developed nation currencies tracked by the Bloomberg Correlation-Weighted Index, while the U.S. dollar has risen 4 percent. The euro has added 8.8 percent to lead gainers, while the yen’s 16 percent drop paces decliners.

Before it's here, it's on the Bloomberg Terminal.