Canadian Dollar Draws J.P. Morgan's Bid as NAFTA Risks Fade

-Canadian Dollar trading at "fair value" against US Dollar.

-Canadian Dollar undervalued against many other peers. 

-J.P. Morgan buys CAD/JPY, where the discount is largest.

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The Canadian Dollar is trading at a steep discount relative to many of its developed world peers following a months-long period of concern about the future of the North American Free Trade Agreement and now risks to the trade pact are abating, strategists at J.P Morgan are advocating that clients bet on a recovery in Canadian Dollar exchange rates. 

This call comes hard on the heels of a week where negotiators from Mexico, Canada and the US all made encouraging sounds about the prospect of a deal "in principle" being agreed during April, potentially as soon as the Summit of the Americas that begins Friday 13, April, which helped pick the Loonie up off of a nine month low against the US Dollar.

A New York Times report Friday claimed Mexican economy ministers are “very convinced” a deal to save the NAFTA pact can be reached soon while US Treasury Secretary Steven Mnuchin also told reporters that negotiators are making “good progress”. Canada’s Foreign Minister, Chrystia Freeland, was more coy when she told the media ““We have always said we’re going to take the time it takes to get a good deal.”  

"We have for most of this year flagged and tracked CAD relative underperformance, particularly versus non-USD peers, and how this has driven a particularly large discount in CAD. While this discount has narrowed somewhat in the past week, it remains materially large," says Daniel Hui, an FX strategist at J.P. Morgan.

President Donald Trump's dislike of the NAFTA agreement is well known after he described it as "the worst deal in history" when on the campaign trail. Canada, Mexico and the US had been attempting to renegotiate it for almost a year, without any meaningful progress, until recent weeks when the White House was reported to have offered a key concession and begun pushing for a token agreeement to be concluded some time this month. 

Analysts have previously estimated that a NAFTA withdrawal by the US could see the Canadian Dollar fall by as much as 20%, which may go some way toward explaining why the Loonie dropped some 5% against its US rival in February and early March when concerns about the US walking away from the deal reached their peak.

But since NAFTA headlines turned more positive the Canadian Dollar has recouped much of its lost ground against the greenback, leaving it with a fractional profit for the 2018 year to date and also putting it close to its "short-term fair value". Nonetheless, J.P. Morgan's Hui says the Canadian currency is still trading at a considerable discount relative to most of its other developed world peers.

"We think there is medium-term value in fading the wide CAD underperformance and discount that has opened up recently versus peers, which in our baseline is not justified by relative monetary policy (4 BoC hikes this year), nor trade risk (no NAFTA crash-out)."

The J.P. Morgan team assume the NAFTA deal will eventually be renegotiated and that this will remove a major source of risk around, as well as downward pressure on, the Canadian Dollar. Once the NAFTA negotiations are over with, and assuming they're succesful, currency markets will be able to renew their focus on Canadian economic fundamentals and the likely path of interest rates. 

This could be positive for the Loonie. The Bank of Canada last raised rates in January, by 25 basis points to 1.25%, and at the time markets were happy betting the central bank would manage a total of three interest rate rises in 2018 as a whole while interest rate derivatives markets assigned a 75% probability to another rate hike in April. Since then, those same markets have become less convinced and are now fully pricing just one more rate rise for 2018, while the implied probability of an April move has fallen to just 20%.

"There are other plausible reasons for a pricing in of a relatively more dovish BoC, including the run of negative data surprises in 1Q. But it is hard to divorce NAFTA risks from the BoC pricing outlook, particularly given that it has been part of BoC’s framework and rhetoric for the past year, particularly since October," Hui notes. "Meanwhile, despite recent data surprises, our economist have not changed their expectations for 4 BoC hikes this year."

If Hui and the J.P Morgan team are right about the Bank of Canada delivering four interest rate rises in 2018 then the Canadian Dollar may well see better days during the months ahead because interest rate derivatives markets, which not only allow investors to protect themselves against changes in rates but also provide insight into expectations for monetary policy, imply a December 05 cash rate of 1.67%.

This is just 41 basis points of additional rate hikes priced in when J.P. Morgan's "four hikes" would require an additional 75 basis points or an implied cash rate of 2%. Any change for the better in the above implied rates, which might be triggered by a NAFTA breakthrough that provides clarity over the outlook for the economy, would be a powerful stimulant for the Canadian Dollar. 

"The potential near-term NAFTA break-through is a potential catalyst for the recent retracement of this underperformance to run significantly further," says Hui. "Therefore we buy CAD/JPY as a best risk-reward expression of CAD underperformance reversal."

Hui and the J.P Morgan team are betting on a rise in the Canadian Dollar relative to the Yen because the Loonie's discount against the safe haven Japanese currency is larger than it is for any other. This means the Canadian Dollar is more "undervalued" against the Yen than it is relative to other currencies. They entered their trade at 84.03 and have placed a stop loss at 82.34.

The CAD/JPY exchange rate was quoted 0.1% higher at 85.01 Wednesday while the USD/CAD rate was down 0.21% to 1.2567. The Pound-to-Canadian-Dollar rate was 0.18% lower at 1.7826.

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