February 1, 2018 / 8:41 PM / a year ago

Canadian dollar diverges from yield spreads as tightening cycle lengthens

TORONTO (Reuters) - The Canadian dollar is ditching its close shadowing of yield spreads, clearing the way for other metrics to drive the currency, as interest rate hike cycles in North America become more established and investors bet on a weaker greenback.

FILE PHOTO: A Canadian dollar coin, commonly known as the "Loonie", is pictured in this illustration picture taken in Toronto January 23, 2015. REUTERS/Mark Blinch/File Photo

The loonie CAD= has tended to closely track the gap in yield between Canada’s 2-year bond CA2YT=RR and its U.S. equivalent US2YT=RR. But the currency and the yield spread have been heading in opposite directions since the beginning of the year.

The weakened link could indicate that investors who bet on the direction of the Canadian dollar need to pay more attention to other catalysts for the currency, such as capital flows and oil prices.

“The two-year spread will become less important as the (rate hike) cycle becomes more predictable or as other drivers become more dominant,” said Mark McCormick, North American head of FX Strategy at TD Securities.

The link to yield spreads has also loosened for some other major currencies, such as the euro EUR=, after the U.S. dollar .DXY broadly fell since November even as the Federal Reserve continued to raise interest rates.

But investors in the Canadian dollar had become used to a nearly perfectly positive correlation between the currency and spreads after the Bank of Canada raised interest rates three times since July, to leave the benchmark rate at 1.25 percent.

The Canadian dollar has completely ignored the shift in yield spreads after having been “attached to the hip” in the second half of last year, said Shaun Osborne, chief currency strategist at Scotiabank.

His model estimates the fair value of the loonie at around C$1.2950, much weaker than the C$1.2300 level it was trading at on Thursday.

“It rather suggests you are seeing a broader move out of U.S. assets,” Osborne said.

Investors are anticipating that global capital flows will shift in favor of currencies other than the greenback, should the European Central Bank and the Bank of Japan terminate massive bond buying programs, strategists said.

Erik Nelson, a currency strategist at Wells Fargo in New York, said that bond markets are signaling the U.S. is closer to the end of its economic cycle than some other major countries, reducing the support of more recent Fed rate hikes for the U.S. dollar.

“It seems like the impetus to allocate capital toward the U.S., relative to a place like the euro zone or Canada is lessening,” he said.

Foreign investors poured more than C$190 billion into Canada’s debt and equity securities in the first 11 months of 2017, on track to reach an annual record. Data for December has not yet been released.

The price of oil CLc1 has been trading in a range that has not been high or low enough to trigger either new investment or cuts to projects already in place in the energy sector, a big part of the country’s economy.

But oil’s correlation to the currency has revived in recent weeks as the price of crude reached a three-year high.

“Right now the market is more focused on commodities,” said Amo Sahota, director at Klarity FX in San Francisco. “Based on interest rate expectations alone, the loonie is probably a little bit overvalued.”

Reporting by Fergal Smith; Editing by Susan Thomas

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