Fundamental Evaluation Series: USD/CAD vs. 2-year yield spread

The chart above shows, how the relationship between USD/CAD and 2-year yield divergence has unfolded since 2012.

• The close relations between the short-term yield spread and the exchange rate is quite visible and the relation, in this case, is closest among all commodity pairs.
• Reserve Bank of Canada (BoC) reduced rates from 300 basis points to just 25 basis points after the financial crisis of 2008/09. It somewhat increased interest rates due to a recovery in oil prices and higher inflows of money from other western economies. It raised rates by 75 basis points to 1 percent in 2010. It started reducing rates again beginning January 2015. The rates steadily declined from 1 percent to 0.5 percent by July 2015, when it signaled a halt.
• It can be seen from the chart that the Canadian dollar declined from a parity against the dollar in 2012 to 1.18 per dollar by the end of 2014. The yield spread during the period rose from -88 basis points to -37 basis points in favor of the US dollar. As the spread continues to rise and reached 13 basis points, the Canadian dollar declined to 1.25 per dollar.
• The spread reached a peak around 56 basis points in January 2016 and the Canadian dollar declined to 1.45 per dollar. By April that year, the spread narrowed to 10 basis points and the Canadian dollar declined rose to 1.25 per dollar.
• While April this year, the spread widened again to a new peak of 63 basis points in favor of the USD, but the Canadian dollar declined only to 1.37 per dollar.
• After BoC signaled a possible rate hike in June, the spread narrowed from 60 basis points to 7 basis points as of August and the loonie has strengthened from 1.35 per dollar to 1.255 per dollar.
• In our review in August, we noted that since the July review, the spread has narrowed by almost 7 basis points in favor of the US dollar and the loonie has declined 180 basis points against the dollar.
• In our early October review, we noted that the spread has moved around 12 basis points in favor of the loonie, and the Canadian dollar strengthened around 80 pips against the dollar.
• In our November review, we noted that after reaching a peak of -4.4 bps in the second week of October, the spread has widened to 20 bps as of early November, in favour of the dollar and the Canadian dollar has responded accordingly by weakening from 1.247 to 1.282 per dollar.

Since that review, the yield spread has risen further by 9 bps to 29 bps, however, the Canadian dollar strengthened by almost 100 pips to 1.271 per dollar, thus contributing to a minor divergence.

The exchange rate is closely following the spread; hence we urge close monitoring.

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