Canadian Dollar Strength to Fade say Strategists

Expectations for further interest rate hikes in Canada may be too optimistic and investors could be underestimating challenges posed to the economy by tighter policy. 

Traders should consider selling the Canadian Dollar against “cross” rivals such as the Japanese Yen and New Zealand Dollar, according to a number of strategists we follow who believe sentiment towards the currency might be too optimistic.

Bullish bets on Canadian Dollar gains rose to record levels in the summer after the Bank of Canada surprised markets by raising interest rates twice within a three month period.

“Certainly, we think that positioning and sentiment is still overly bullish but we wouldn’t pair that view with a long USD spot position at this point,” says Bipan Rai, a macro strategist at CIBC Capital Markets. “We like fading CAD strength on the crosses including versus the JPY and NZD.”

Since September the Canadian economy has slowed and the BoC has begun to sound more dovish, but exchange data has shown many of those same bullish bets remaining stubbornly in place.

“We’ve been short CAD/JPY for weeks now but we’re exploring a tactical long NZD/CAD trade as well. Enough bad news has been priced into the NZD and we feel that it is due to recover on reversion in the coming weeks,” adds Rai.

Above: NZD/CAD rate shown at daily intervals.

Overnight Index Swaps prices still suggest, according to some strategists, a more than 30% chance the Bank of Canada will raise interest rates again in January. Many would agree this is a 30% probability too high. CIBC forecasts the next interest rate rise to come from the BoC will not be until June 2018.

“CAD, AUD and NZD to weaken with rising global funding costs,” say Hans Redeker and James Lord, both foreign exchange strategists at Morgan Stanley. “These 'canaries in the coal mine' with stretched balance sheets should underperform.”

For some countries, Canada included, the higher that interest rates go, the lesser their respective currencies are likely to appeal to investors in an environment where other central banks are also raising rates.

“The 'canaries' have seen years of economic growth outpacing income growth,” say Redeker and Lord. “The dominance of US rates in determining global funding costs resulted in local funding costs remaining inappropriately low, given the local needs of these economies, leading to a leverage boom.”

Low inflation, which is believed to be a symptom of low wages growth, has been a persistent concern of developed world central banks in recent years. This has nurtured secondary concerns over the impact that an eventual increase in interest rates will have on debt laden households.

“Now, as these economies are running out of balance sheet leverage space, which reduces their growth potential, the US is pushing nominal rates gradually higher, creating further headwinds,” the Morgan Stanley team write in their 2018 strategy book.

The Bank of Canada raised its cash rate from 0.50% in June to 1% by the end of September. The Federal Reserve has raised its policy rate from a 0% - 0.25% range in late 2015 to a 1% - 1.25% range in June.

“High real returns in Emerging Markets and rising US rates mean that the yield advantage offered by these economies relative to G10 counterparts may no longer be sufficient to compensate investors for these growing risks,” add Redeker and Lord.

Above: USD/CAD rate shown at daily intervals.

The implication of the "canary in the coalmine" idea is two-fold. In the first instance, canary currencies may lose ground to others whose central banks are also raising rates, but where those other currencies are backed by less debt laden economies.

In the second instance, and further down the line, central banks that are standing behind canary currrencies may ultimately be forced to reverse course and cut rates in response to the adverse economic effects of higher borrowing costs meeting with overstretched households.    

The Morgan Stanley team have recommended clients bet on a rise in the USD/CAD rate during 2018. They suggest entering the trade when the rate rises to 1.2800 and targeting an upward move to 1.3800. They also advocate betting on an increase in the EUR/CAD rate over the same time period.

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