Leads and lags

There are no hard and fast rules explaining the CAD exchange rate given the interest-rate differentials between the two countries. Given the mechanics of controlled interest- rate arbitrage, we should expect a relationship between the six-month rate differential and the normal three month non deliverable forward. This is visible when CAD LIBOR trades over USD LIBOR. It is not as visible when the LIBOR relationship reverses, as has been the case in late 2005. At no point in the past 15 years has the divergence between the LIBOR differentials and the exchange rate been as great.

This divergence demands explanation. Although currency trades tend to be dominated by short-rate differentials, activity at the long end of the yield curve is related more closely to the CAD itself. This is a capital market phenomenon, one related to both note yields and to stock market activities. Once the equity bear market ended in October 2002, U.S. 10-year T-note yields rose relative to Canadian 10 year note yields. The CAD strengthened apace. Prior to October 2002, no such relationship was visible. This suggests the U.S. has to pay a risk premium for capital relative to what Canadian borrowers pay; such a premium is linked to the risk of ultimate repayment of principal. The U.S. is seen as a riskier credit than Canada by international creditors.