Many observers saw Canada as one of the canaries in the coal mine, warning that the divergence theme was over. The Bank of Canada did hike rates twice in Q3. The Federal Reserve did not hike at all. Isn’t that the definition of convergence?
Yes and no. The Bank of Canada’s rate hikes were not the beginning of a sustained effort to normalize policy. The hikes were largely about removing the accommodation provided in 2015 as Canada was hit by a terms of trade shock when oil prices tumbled. With a December Fed seen as highly probable, the spread between the policy rates will finish wider than they started the year.
The US-Canadian dollar exchange rate is very sensitive to two-year interest rate differential. The first Great Graphic here, created on Bloomberg shows this correlation on a rolling 60-day basis. Here we ran the correlation on the level of the US-Canada exchange rate. The US dollar moved in the same direction as the interest rate differential 90% of the time over the past 60 days. The correlation has been above 0.90 for more than three months.
The second Great Graphic depicts the two time series, the USD-CAD exchange rate than the two-year interest rate differential. We are not so fond of such charts (two time series and two scales) but in this case, it cannot be avoided, and we are suggesting eyeballing the correlation, which is why we show that work first.
This chart shows the co-movement of the exchange rate and the two-year interest rate differential.
The differential peak in May within days of the dollar’s peak. The differential narrowed as the market understood the signals from the Bank of Canada of the likelihood it would hike in July and September.
The market had to be led by Fed officials to price in both the March and June hikes. It became clearer around the middle of the year that the Fed would shift toward its balance sheet operations at the September FOMC meeting, which did.
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