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Traders should buy dips in USD/CAD because the Canadian dollar is likely to underperform as the US economy heads for a soft landing and the Federal Reserve begins to cut interest rates, according to Barclays research.

“Canada's dependence on the US as an export market means US slowing presents downside risks to a Canadian economy that is already under pressure,” Barclays strategists said in a Wednesday research note.

“In our base case of a US soft landing, we would expect cyclical currencies like CAD to find support. However, CAD should underperform in such a scenario,” they added.

A high sensitivity to changes in US growth momentum means Canada’s economy would come under added pressure as its southern neighbour slows, and this could necessitate a relatively more dovish interest rate stance from the Bank of Canada that would likely weigh on the Loonie, according to Barclays.

Above: USD/CAD shown at daily intervals with selected moving averages.

That and the loose positive correlation between the trade-weighted Canadian and US dollars is why the Barclays team expects the Loonie to underperform once the Fed begins to cut rates.

This is partly because a ‘soft landing’ of the US economy has tended to weaken the US dollar in past cycles, and as the trade-weighted Canadian dollar tends to follow the broad US dollar lower in such circumstances.

“As we head towards the first Fed cut and markets decipher whether we are transitioning to a hard landing, downside risks to CAD are mounting,” Barclays said. “We would look to buy USD/CAD on dips towards 1.36.”

Markets have bet confidently in recent weeks that the Fed will cut rates from September and multiple times thereafter owing to a string of poorer than expected economic figures out from the US in late July.

Above: Pound to Canadian dollar rate shown at daily intervals alongside USD/CAD.

However, the US is still thought to be on course for a soft landing and the upside potential for USD/CAD would be greatest in a hard landing scenario, which would likely see the Loonie strengthen in trade-weighted terms.

“Of the cyclical commodity currencies CAD has the lowest beta to a risk-aversion shock. That means that despite a direct negative impact on the Canadian economy from a US recession, CAD would likely outperform other cyclical commodity currencies in a hard landing,” the Barclays team said.

“In our base case of a soft-landing, the domestic backdrop detailed below, as well as the historical experience, indicate that CAD would underperform other cyclical commodity currencies,” they added.

The Canadian Dollar’s tighter correlation with the US Dollar means GBP/CAD would normally be seen falling when USD/CAD rises, and vice versa, with GBP/CAD gaining as USD/CAD declines.