Investors, caution: There may be some turmoil in the store for the loonie



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Scott Barlow, Market Strategist at Globe Investor, writes exclusively for our subscribers at Inside the Market.

Street forecasts for the credit markets show a positive outlook for the loonie in 2019. But in light of a recent series of weak internal economic reports, investors may want to lower their expectations for the currency.

The Canadian dollar's high sensitivity to relative returns – the government's two-year bond yield minus the US Treasury's two-year yield – is illustrated in the first chart (at the end of the article). The price of oil is still important in determining the value of the loonie (we will get to that point), but in the last five years, correlation analysis indicates that yields have had a greater impact. Higher domestic bond yields relative to US yields supported the value of the Canadian dollar.

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On Tuesday, domestic bond yields traded at 1.86 percent and Treasury yields were 2.57 percent, leaving a spread of minus 71 basis points (a base point is one-hundredth of a percentage point ). The dollar is trading at about 75.5 cents.

The consensus economist's forecast points to a 2.39% yield for the two-year Canadian bond and 2.93% for the two-year US yield at the end of 2019. This means that the yield spread is expected to decline to minus 54 basis points. In the chart, the tightening of the spread would be represented by a rising purple line and, based on previous performance standards, would significantly raise the domestic currency.

Bank of Canada rate increases and economic growth are the two factors that should push bond yields up 2.39%. At this time, the market is pricing two Bank of Canada rate increases this year and gross domestic product growth of 1.9%.

All this would be good with regard to forecasts, if recent indications did not show that the Canadian economy declined in November. Disappointing results for the month of November Domestic retail sales – which were estimated to fall by 0.6%, but fell below 0.9% – and also the wholesale trade and manufacturing sales, have economists estimating 0.1 per contraction when GDP data is released Thursday.

November is only a month and the growth trend may improve. However, the economy is clearly slowing down and this makes bond yields much less likely. The Bank of Canada is unlikely to raise interest rates when faced with a contracting economy and the 1.9% GDP growth estimate for 2019 is also at risk.

The threat to 2019 GDP growth was apparent in a Merrill Lynch report citing economic growth risks for its downgrade of Bank of Montreal from "neutral" to "underperform." In a Jan. 28 report, analyst Ebrahim Poonawala wrote, "We believe investors may be underestimating [BMO’s] risk of revenue from the deceleration of GDP growth "due to its exposure to commercial loans.

Slower growth and lower rate increases imply lower bond yields, an increase in bond spread (depending on US economic reports and Federal Reserve policy, of course), and a weaker and no stronger loonie.

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Oil prices are the only factor that could justify the current bullish outlook for the national currency. Our second chart (below) shows that oil prices, both Western Canada Select and West Texas Intermediate, had an influence on the loonie, even though the correlation is less strong than between the spreads and the dollar. Higher oil prices have consistently been accompanied by a stronger currency.

BMO chief economist Doug Porter acknowledges that growth prospects and monetary policy do not support the strength of the Canadian dollar. But in an interview, he adds, "one thing that could circle the predictions square … would be a rebound in oil prices (and / or a generally weaker USD) … would strengthen the case of Bank of Canada increases as well as support narrowing in two-year spreads. But more broadly … given the pronounced softness in domestic demand recently, even two BOC rate increases this year seem increasingly shot in the dark. "

Is the optimistic outlook of Loonie justified?

2 years. Propagation: 2 years. Gov't of CanadaBond

Yield less 2 years. US Treasury yields

Western Canada Select

crude oil (US $ / bbl, on the right)

WTI Crude (US $ / bbl, right)

JOHN SOPINSKI / THE GLOBE AND THE MAIL

SOURCE: scott barlow; bloomberg

Is the optimistic outlook of Loonie justified?

2-year spread: Canada's 2-year government

Yield of Bond less US Treasury yield in 2 years

Western Canada Select

crude oil (US $ / bbl, on the right)

WTI Crude (US $ / bbl, right)

JOHN SOPINSKI / THE GLOBE AND THE MAIL

SOURCE: scott barlow; bloomberg

Is the optimistic outlook of Loonie justified?

Two-year spread: Canada's two-year government

Yield of Bond minus US Treasury yield of two years

Western Canada Select

crude oil (US $ / bbl, on the right)

WTI Crude (US $ / bbl, right)

JOHN SOPINSKI / THE GLOBE AND THE MAIL, SOURCE: scott barlow; bloomberg

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