Photographer: Pawel Dwulit/Bloomberg

Loonie Bulls Face Risk in Widening U.S.-Canada Two-Year Spread

  • Correlation of spread and USD/CAD is close to perfect
  • TD sees more spread widening in weeks ahead, barring shock

Canadian dollar bulls, sporting a gain of nearly 8 percent against the U.S. dollar over the past three months, can’t ignore the widening yield gap between U.S. and Canadian two-year debt.

The exchange rate is almost perfectly correlated with the yield differential over the past three months, and Toronto-Dominion Bank analysts say additional widening is possible as soon as Friday based on U.S. inflation data. If the loonie continues to follow its lead, the currency could extend its recent weakening against the dollar in the weeks ahead.

A three-month correlation of 0.99 is “extraordinarily high” and well above the 0.61 average since January 2000, BMO Capital Markets strategist Greg Anderson said. The interest-rate spread has been a key driver for the loonie in recent months because of its sharp moves, Anderson said, as traders set positions based on the most volatile variables.

He expects the correlation to begin decelerating in November or December, after a likely interest-rate increase by the Bank of Canada. At that point, oil will probably reassert itself as a driver, Anderson said.

Last month, the fastest Canadian economic growth in 17 years helped drive Canadian two-year yields to within a whisker of similar-maturity Treasuries. The spread shrank to two basis points, the narrowest since 2015. The loonie reached C$1.2414 at the end of last month, the strongest since 2015, and traded at C$1.2677 on Thursday.

The U.S. Consumer Price Index for July has the potential to lift market-implied expectations for another Fed rate increase this year from levels TD deems “severely underpriced,” supporting the bank’s call for Canadian two-year debt to outperform the U.S. two-year.

“We’ve seen the turning point,” senior fixed income strategist at TD Andrew Kelvin said of the bond yield spread. “Barring an economic shock -- let’s say a series of very negative U.S. prints or somehow Canada surprising even further to the upside,” the yield spread is set to widen.

If the correlation holds, the loonie could get caught in its grip.

— With assistance by Maciej Onoszko

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