The Canadian dollar’s exchange rate to its US namesake remains closely correlated with the S&P 500. The relationship makes sense. Broadly speaking, the benchmark stock index represents investors’ collective earnings outlook for the world’s top companies, making it a de-facto proxy for global economic growth. Meanwhile, Canadian economic growth (and thereby the path of its monetary policy as well as the currency) is firmly anchored to trends in US demand considering some 80 percent of the country’s wares are exported to its southern neighbor. The US being the world’s top economy, the trajectory of its growth and the globe at large are closely parallel, explaining the link between USDCAD and the S&P 500.

Since the beginning of May, this has broadly translated into losses for the Canadian currency as traders began to unwind bets on stocks going higher ahead of the expiration of the Federal Reserve’s QE2 monetary stimulus program. The logic here was two-fold. From a short-term perspective, QE2 flooded the markets with money to bring down interest rates and traders capitalized by borrowing US Dollars on the cheap to invest them into higher-return assets (including stocks, commodities, etc). Speculative bets are not mortgages, and investors rarely lock in interest rates for extended periods of time to maintain flexibility; this means that as QE2 ends and borrowing costs begin to rise, investors will be faced with the reality that maintaining their USD-funded trades will become increasingly expensive. Knowing this would likely be the case, markets began to unwind QE2-dependent positions, bringing shares and correlated currencies – CAD included – along for the ride. From a longer term respective, higher borrowing costs will weigh on economic growth as individuals and companies find it more expensive to consume or invest on credit, slowing the recovery and trimming the earnings outlook for S&P 500 companies to pressure the index as well as the Canadian unit lower.

Looking ahead, the move lower is poised to accelerate. Ben Bernanke put the current landscape in sharp relief last week, simultaneously sounding the alarm about “uneven” and “frustratingly slow” recovery while apparently dismissing the possibility of further stimulus, placing emphasis on limiting inflation and alluding to the “prospect of increasing fiscal drag” on the economy (implying the Fed is expecting US Treasury bond yields to rise as QE2 expires). Investors have clearly taken notice, and the S&P 500 has swooned. More of the same seems almost certainly ahead, with the Canadian Dollar quick to follow.

DailyFX provides forex news on the economic reports and political events that influence the forex market.