Monday, 21 April 2014

A long look at the CAD

The Canadian Dollar has been one of the most consensus short trades so far this year, and possibly the only performing consensus trade YTD, with the CAD down 3.5% so far, but off its lows.

Goldman Sachs, and many others came out loudly, suggesting short CAD for many reasons, but summed up by the following

·         Canada’s current account position has been in deficit for some time
·         Slowing reserve diversification into the CAD has recently pushed the BBoP into deficit
·         The BoC is also concerned about weakness in the export sector and low inflation
·         Domestic demand may no longer receive a boost from the housing market
·         The BoC is one of the few central banks with scope to cut rates
·         US growth and tapering may move interest rate differentials further against the CAD
·         In particular, a sell-off in the US front end could significantly accelerate a $/CAD rally

     
 This has led to forecasts ranging from a median estimate of 1.14 by 2015, to highs at around 1.22 vs the USD.
USDCAD reuters poll
Implied volatility out to year end is around 6.5, implying a breakeven move of about +/-560 points from ATM (1.1015)

·         Canada’s current account position has been in deficit for some time
·         Slowing reserve diversification into the CAD has recently pushed the BBoP into deficit

Addressing the points raised by the sell side, I believe the CAD to be less vulnerable than they suggest and potentially outperform many other currencies in the medium term. 

Tending to each one in turn, Canada's Current account sharply fell into deficit post 2008, but has stayed remarkably constant since, especially when considering the CA of say the UK which is a majorly concerning factor

(read more from this DB note on UK CA - http://pull.db-gmresearch.com/cgi-bin/pull/DocPull/3004-6FD6/80951965/DB_SpecialReport_2014-04-15_0900b8c0881c43e2.pdf)

·         The BoC is also concerned about weakness in the export sector and low inflation

The BoC is most certainly concerned regarding inflation outlook, particularly core CPI as can be seen from their last Meeting where they state 

*BOC: CORE INFLATION EXPECTED TO STAY WELL BELOW 2 PCT IN 2014 DUE TO EFFECTS OF ECONOMIC SLACK

Looking at a chart of CPI and Core CPI we can see that the BoC really should be far less concerned about disinflationary pressures than say the US, Eurozone or the UK and this will filter onto to latter points regarding monetary policy

Canadian CPI and Core CPI

·         Domestic demand may no longer receive a boost from the housing market

Housing is also a major concern, especially considering the ramifications on Aggregate demand, but relatively speaking its no more concerning than the sluggish housing recovery from the US, the newly booming UK housing market or the more worrying NZ / scandanavian housing markets. So looking at this factor, while its not ideal for Canada, a global drift lower in housing will impact other places more so than Canada.

·         The BoC is one of the few central banks with scope to cut rates
·         US growth and tapering may move interest rate differentials further against the CAD


Some are calling for the BoC to cut rates, some are just expecting a far more dovish outlook. however in light of inflation, both Core and normal, I see no reason for the BoC to even consider a rate cut.

When looking at key drivers of inflation, such as energy prices, we can see that in CAD terms Oil prices are around 10% higher YTD

Oil in CAD

And even though the BoC have cited upward pressures from energy on inflation, I feel the market for interest rates incorrectly interpret the wording from the BoC regarding future rate moves. Even though the BoC is in a neutral stance (where they consider both cuts or hikes) I believe the next move to certainly be a hike.

Especially considering the growing growth prospects of Canada with its close ties to a strongly performing US economy, not only this, recent geopolitical moves, such as the Canadian-South Korean Free trade Agreement will only help Canada's presence in the growing East. 

·         In particular, a sell-off in the US front end could significantly accelerate a $/CAD rally

And yes, the interest rate spread vs the US, especially on the short end may benefit the USDCAD which can be seen by the tight correlation between the 2yr swap spread and the spot price

USDCAD vs 2 year yield spread
Therefore we can see how a lot of the move higher in the USDCAD has been due to pricing the relative moves in the central bank policy - that is a dovish BoC and a hawkish Fed.

However considering upward pressure to CPI in the medium term, decent growth prospects (maybe less than the US, but better than most) and mostly stable macroeconomic indicators (U/E, CA etc, housing) I feel that some of the dovishness in the CAD is overstated and hence I am looking to build a position more closely aligned with a move toward a less dovish BoC

The question is where to fund the long CAD position, this is possibly the hardest question. I am still marginally bullish the USD in the 3, 6, 12 month outlooks, and I think the best opportunities come against the NZD, the CHF and the GBP.

In the case of the NZD and GBP vs the CAD, it can be seen that positioning is at extremes (taken via 25 delta 3 month risk reversals) and is therefore vulnerable to covering

CAD blue, NZD green, GBP red

My final chart looks at 1 year swap rates 2 years forwards as a proxy for monetary policy between the UK and Canada, and we can see strong convergence (red UK, blue Canada) between respective rates, and the spread is shown in green overlayed vs the GBPCAD cross rate. Once again, to me its clear that the weakness in the CAD is due to over-expectations regarding the dovishness of the BoC which I think will change soon. 



In terms of how I would play this, I don't see any simple opportunities in the volatility or rates markets that would overly differ from that of a spot trade pay-off and as such I'd look to buy the CAD vs. a basket of currencies with the weighting;

 25% vs. the NZD,
 35% vs. the GBP
 40% vs. the CHF.


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