Undervalued Canadian Dollar Reaches Crossroads on the Charts

“A break of either side should open the way for a decent move higher/lower” RBC Capital Markets. 

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The Canadian Dollar outperformed most other currencies in the penultimate session of the week but some measures suggest it’s increasingly undervalued in pairs like USD/CAD and GBP/CAD, which might be more appropriately valued nearer 1.30 and 1.60 respectively.

Canada’s Dollar gave way to a widespread rallying U.S. Dollar on Thursday while climbing against all other major currencies amid a sell-off in government bond markets, which took place against a backdrop of gains for industrial metals and a mixed picture for stock markets. 

The rally came amid a cacophonic collection of remarks from Federal Reserve officials including Dallas Fed President Lorie Logan, who reportedly suggested that U.S. interest rates could be raised further in June. 

Thursday’s price action followed a tick higher for inflation closer to home in Canada on Wednesday, which was trailed by an increase in Canadian government bond yields and a rise in implied expectations for the Bank of Canada (BoC) cash rate.

“Canada’s forward curve is priced for one more hike in H2, with only marginal risk of cuts in Q1 ’24,” writes Elsa Lignos, global head of FX strategy at RBC Capital Markets, in a Thursday research briefing.

Above: USD/CAD shown at daily intervals alongside spread or gap between 02-year government bond yields. Click image for closer inspection. 

“It may look like an argument to be long USD/CAD but it’s not so straightforward. Our CAD model shows based on typical elasticities, the MTD move in 2y rate spreads would have pushed USD/CAD down by 2%. Yet USD/CAD is only slightly lower in net terms,” she adds.

RBC models suggest earlier losses for things like stocks, crude oil and other commodities could only explain around half a percent of the Wednesday increase in USD/CAD, while since then some of those moves have gone into reverse. 

“There is a wide band of no-mans-land with falling resistance coming in at 1.3590 and rising support at 1.3320 (spot 1.3465-70). A break of either side should open the way for a decent move higher/lower,” Lignos says. 

The recently reduced bond spread suggests USD/CAD might be more likely to break down to 1.31 than break above 1.3590, while it’s also possible to argue that 1.26 would be more appropriate or 'fair value', given the current level of interest rates and inflation in the U.S. and Canada. 

Similar is true of GBP/CAD. while it's possible that recent narrow ranges are a reflection of uncertainty about the outlook for inflation and the timeframe over which it might be likely to return to the two percent target. 

Inflation is a negative influence for the ‘fundamental value’ of currencies whenever not offset by matching increases for interest rates, although exchange rates have been known to respond to it in the opposite way at times. 

Above: GBP/CAD shown at daily intervals alongside spread or gap between 02-year UK and Canada bond yields. Click image for closer inspection.