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 in 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.
- Since the signaling of reversal, Canada has raised rates four times by 25 basis points each.
- In our review in August 2017, 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 favor of the dollar and the Canadian dollar has responded accordingly by weakening from 1.247 to 1.282 per dollar.
- In our next review, we noted that 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 the divergence.
- In the mid-December review, we noted that the spread has declined by 9 basis points to 20 bps and Loonie has weakened by 30 pips to 1.274.
- In our January review, we noted that a divergence has started setting in as the yield spread widened by 9 bps to 29 bps in favor of the dollar, while loonie has strengthened by more than 400 pips and was trading at 1.232 per dollar.
- In our February review, we noted that the spread has further widened by 15 bps to 44 bps in favor of the dollar and the loonie has weakened by 340 pips to 1.266 per dollar.
- In our April review, we noted that since February, the spread hasn’t changed as it stands at 44 bps, while the Canadian dollar strengthened by 80 pips to 1.258 per dollar.
- In May, we noted that has widened sharply in favor of the dollar by 12 bps to 56 bps and the Canadian dollar responded accordingly by declining 190 pips to 1.277 per dollar.
- In June, the spread further widened by 7 bps to 63 bps and the Canadian dollar weakened to 1.314 per USD.
- In July, the spread widened by 3 bps to 66 bps and the Canadian dollar declined a bit further to 1.316 per USD.
- One must note that the spread has started to decline and in August it dropped to 54 basis points but the Canadian dollar hardly changed at 1.315 per USD. If the spread continues to decline, we might see a sharp reversal in the Canadian dollar.
- In September 2018, we noted that the divergence has started to widen again, which means that the market focus is turning away from the rate differentials. While the Spread widened by 10 bps to 64 bps in favor of the USD in September, the Canadian dollar strengthened to 1.291 per dollar.
In October, the exchange rate has once again succumbed to rate differentials. As the spread widened to 66 bps points in favor of the USD, the Canadian dollar declined from 1.291 per USD to 1.311 area.