By Howard L Simons
othing infuriates Canadians more than the sense Americans are ignoring them. This indignation is justifiable in light of the importance of the U.S.-Canada bilateral
FIGURE 1 — CANADIAN DOLLAR PULLS AHEAD
The Canadian dollar has been the strongest currency vs. the USD since the euro was introduced in January 1999.
FIGURE 1 — CANADIAN DOLLAR PULLS AHEAD
Data source: Bloomberg trade flow; each country is the other's largest trading partner.
The Canadian dollar (CAD) is an important financial variable, too. Not only does it account for 9.1 percent of the benchmark dollar index (DXY), but it occupies a unique role therein. None of the five other currencies in the DXY can claim the CAD's combination of dependence on cross-border trade and investment flows and interest-rate differentials and commodity linkages. Once we understand what drives the CAD, we have a critical piece in place for understanding the DXY.
The CAD is and has been stronger against the U.S. dollar (USD) than can be accounted for by interest-rate differentials alone. Commodity prices are a contributing factor. And while the euro and Japanese yen, with their 57.6-percent and 13.6-percent weights in the DXY, respectively, garner the lion's share of attention, the CAD has been the strongest performer against the USD since the Jan. 4, 1999 introduction of the euro (see Figure 1). Canadians may note this has escaped the attention of the financial headline writers.
Data source: Bloomberg
The role of the yield curves
Let's use the forward rate ratio (FRR)
between 2 and 10 years as a measure of the yield curve's steepness. This measure is the forward rate between 2 and 10 years, divided by the 10-year rate itself. The more the FRR exceeds 1.00, the steeper the yield curve. A FRR less than 1.00 indicates inversion.
Prior to the Federal Reserve's embarkation on aggressive rate easing in spring 2001, the U.S. and Canadian FRRs were nearly identical. Once the Federal Reserve eased aggressively and the Bank of Canada did not match, the CAD began to strengthen (Figure 2).
The major monetary policy divergence occurred in the aftermath of Sept. 11 and extended into the Spring of 2004, a period highlighted with a box in Figure 2. The CAD continued to firm both throughout this period and well into 2005, despite the fact that U.S. monetary policy became tighter than its Canadian counterpart in early 2005.
A second way to illustrate this phenomenon is the absolute spread between CAD and USD LIBOR as a percentage of the USD LIBOR. Short-term CAD swap rates stood well over USD rates by mid-2003, a move certainly supportive of a stronger CAD (Figure 3). By mid-2005, the yield advantage switched to the USD, which should have weakened the CAD if it was the only factor. The USD advantage started to erode by late 2005, a period in which the CAD moved to a multi-year high against the USD.
The comparative USD and CAD yield curves have remarkably parallel shapes as of late-December 2005 (Figure 4). The CAD curve is a little steeper at the money-market maturities (those less than one year), while the USD curve is noticeably flatter at the note maturities (those between one and 10 years).
continued on p. 34 CURRENCY TRADER • February 2006
FIGURE 2 — POST SEPT. 11 POLICY DIVERGENCE HAS CLOSED
Before the Fed's aggressive rate-cutting cycle in spring 2001, the U.S. and Canadian FRRs were nearly identical. When the Fed eased aggressively but the Bank of Canada did not, the Canadian dollar strengthened. The major monetary policy divergence followed Sept. 11 and extended into spring 2004.
Data source: Bloomberg
FIGURE 3 — CAD/USD SWAP RATE DIFFERENTIALS RISING FROM MULTI-YEAR LOWS
Data source: Bloomberg
FIGURE 3 — CAD/USD SWAP RATE DIFFERENTIALS RISING FROM MULTI-YEAR LOWS
Short-term CAD swap rates were well above USD rates by mid-2003, which would support a stronger CAD. By mid-2005 the yield advantage had switched to the USD, which should have weakened the CAD. The USD advantage started to erode by late 2005, a period in which the CAD moved to a multi-year high against the USD.
- Data source: Bloomberg
FIGURE 4 — COMPARATIVE YIELD CURVES, DEC. 23, 2005
The USD and CAD yield curves present remarkably parallel shapes, although the CAD curve is somewhat steeper at the money market maturities, while the USD curve is flatter at the note maturities.
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