While economists have been warning that divergence in fiscal policy between the Bank of Canada and the United States Federal Reserve could send the Canadian dollar into a tailspin, at least one believes a bigger threat to the loonie may be lurking across the pond.

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Avery Shenfeld, managing director and chief economist at CIBC Capital Markets, said in a note to clients Friday that he believes currency investors should be keeping an eye on the euro.

“While monetary policy divergences can impact the Canadian dollar, its broadest movements against the greenback have more often been a reflection of whether the U.S. dollar is generally weakening or strengthening against a basket of major currencies,” he wrote in the note.

“The euro is the most heavily weighted developed-currency alternative to the greenback. As a result, in the past two decades, there’s been an 85 per cent correlation between monthly average levels for the euro’s exchange rate versus the USD and the Canadian dollar’s valuation against the greenback.”

While Shenfeld believes the euro is poised for a rebound against a greenback that has been bid up to the point where it is overvalued — a scenario that would be positive for the loonie — there is an alternative outcome that could emerge if eurozone countries hold the line on recent austerity measures.

If, as a result of belt tightening, the European Central Bank is forced to ease more than expected and the Fed slows its own easing as the U.S. economy stays strong, the greenback could renew its run and the loonie could be vulnerable, Shenfeld argued.

“Odd as it might seem, keeping an eye on budget decisions in Germany, France, Italy and other major eurozone members is of importance for those with Canadian dollar risks to hedge,” he said.

While the Bank of Canada has hinted that key interest rate cuts could come as soon as its next decision on June 5, the Fed is waiting for further economic softening.

In a note to clients last month, Derek Holt, vice-president and head of capital markets economics at Bank of Nova Scotia, warned that it would be difficult for the Bank of Canada to cut rates ahead of the Fed ”without causing CAD (the Canadian dollar) to crater.”

Some economists, however, have downplayed the risk that divergence poses to the loonie. This month, National Bank of Canada economists Taylor Schleich and Warren Lovely said they believe the Bank of Canada could diverge from the Fed by as much as 100 basis points “without policymakers batting an eye.”

Shenfeld, too, said that while he does expect the loonie to lose a few cents on divergence from the Fed, the losses would not likely be sustained into 2025.

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