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Investors beware: there may be some turbulence in stock for the loonie



Scott Barlow, domestic market strategist for Globe Investor, writes exclusively for our subscribers in Inside the Market.

Street credit market forecasts provide a positive outlook for Canadians in 2019. But in light of the recent series of weak domestic economic reports, investors may want to curb their expectations for the currency.

The high sensitivity of the Canadian dollar to relative returns – the yields of two-year bonds of the Canadian government minus the two-year returns of the US Treasury – is shown in the first graph (at the bottom of the article). The price of oil still matters in determining the value of the Canadian dollar (we will return to this), but over the past five years, correlation analysis shows that the yield has had a greater impact. Higher yields on domestic bonds compared to yields in the United States supported the value of the Canadian dollar.

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On Tuesday, the yield on domestic bonds was trading at 1.86 percent, and the yield on treasury bonds was 2.57 percent, resulting in a spread of minus 71 basis points (one base point is one hundredth of a percentage point). The dollar is trading at about 75.5 US cents.

The economist's consensus forecast indicates a yield of 2.39% for a Canadian two-year bond and 2.93% for a two-year US yield at the end of 2019. This means that the yield spread is expected to narrow to minus 54 basis points. On the graph, the narrowing of the spread will be represented by an ascending purple line, and, based on previous performance models, this will significantly push the national currency.

The increase in the Bank of Canada rate and economic growth are two factors that are expected to raise bond yields from current levels to 2.39 percent. At present, the Bank of Canada estimates the market with two rate hikes this year and a 1.9 percent increase in gross domestic product.

All this would be good if forecasts were made if the latest data does not show that the Canadian economy contracted in November. The disappointing results of domestic retail sales in November-month, which, according to estimates, fell by 0.6 percent, but did not even reach this number, decreased by 0.9 percent, as well as wholesale and sales, made economists forecast 0.1%. percentage estimate. cents decline when GDP data is released on Thursday

November is just one month, and the growth trend may improve. However, the economy is clearly slowing, and this greatly reduces the likelihood of higher bond yields. The Bank of Canada is unlikely to raise interest rates when faced with a shrinking economy, and the GDP growth estimate of 1.9 percent for 2019 is also under threat.

The threat to GDP growth in 2019 was evident in the Merrill Lynch report this week, citing risks of economic growth to lower the Bank of Montreal from “neutral” to “low”. In a January 28 report, analyst Ebrahim Punawalla wrote: “We believe that investors may underestimate [BMO’s] income risk from a slowdown in GDP growth ”because of its exposure to commercial lending.

Slower growth and lower interest rates imply lower bond yields, widening bond spreads (of course, depending on US economic reports and Federal Reserve policies), and a weaker, but not stronger, Canadian.

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Oil prices are the only factor that can justify the current bullish outlook for the national currency. Our second chart (below) shows that both Western Canada Select and West Texas Intermediate crude oil prices have affected Canadians, even if the correlation is less strong than between spreads and the dollar. The rise in oil prices was constantly accompanied by a strengthening of the currency.

BMO chief economist Doug Porter admits that growth prospects and monetary policy do not support the strengthening of the Canadian dollar. But in an interview, he adds, “one thing that could turn into a square of forecasts … it would be a rebound in oil prices (and / or a weaker US dollar overall) … it would strengthen the arguments for increasing Bank of Canada, as well narrowing in two-year spreads. But, in a broader sense … given the recent weakness in domestic demand, even two rate hikes by the BOC this year are becoming more and more distant. "

Is bullish forecast justified for loonie?

2-year. Distribution: 2 years Government of CanadaBond

Yield minus 2 years. US Treasury Income

Western Canada Select

crude oil (US $ / bbl, right)

WTI Crude (US $ / bbl, right)

JOHN SOPINSKY / GLOBE AND MAIL

SOURCE: Scott Barlow; Bloomberg

Is bullish forecast justified for loonie?

2 years distribution: 2 years government of Canada

Bond yield minus 2-year yield of US Treasury bonds

Western Canada Select

crude oil (US $ / bbl, right)

WTI Crude (US $ / bbl, right)

JOHN SOPINSKY / GLOBE AND MAIL

SOURCE: Scott Barlow; Bloomberg

Is bullish forecast justified for loonie?

Biennial Spread: Biennial Government of Canada

Yield of bonds minus two-year yield of US Treasury bonds

Western Canada Select

crude oil (US $ / bbl, right)

WTI Crude (US $ / bbl, right)

JOHN SOPINSKY / GLOBE AND MAIL, SOURCE: Scott Barlow; Bloomberg


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