Canadian Dollar Most at Risk

When the U.S. Fed begins tapering its quantitative easing program, the Canadian dollar will face more risk than other G-7 currencies.

Canada’s dollar is emerging as the Group of Seven (G-7) currency with the most at stake as traders debate whether the U.S. Federal Reserve will announce a reduction in its unprecedented monetary stimulus as soon as today.

The loonie and U.S. 10-year Treasury note yields are the most inversely correlated since August 2004, increasing faster in 2013 than any other G-7 peer apart from the U.S. dollar. That means any rise in U.S. yields should the Fed taper its $85 billion in monthly bond purchases may weaken Canada’s currency, which is already down 6.8 percent this year.

The Canadian dollar is particularly sensitive to Fed policy because the countries are each other’s largest trading partners. The correlation increased as the U.S. considered reducing stimulus and the Bank of Canada stepped back from a pledge to move interest rates higher.

“We’re in the process of seeing a divergence in monetary policy,” Paresh Upadhyaya, the Boston-based director of currency strategy at Pioneer Investment Management Inc., said in a Dec. 16 phone interview. “Canada can be expected to keep a very loose, accommodative monetary policy, in contrast to the Fed, which is set to start its tightening cycle.”

Pioneer, which oversees $215 billion, is underweight the Canadian dollar and would “look to add to that position on any rally,” according to Upadhyaya. The firm expects the loonie to weaken to C$1.10 per U.S. dollar or lower over the next six to 12 months, from C$1.0639 at 8:24 a.m. in New York.

The 150-day inverse correlation between the Canadian dollar and U.S. 10-year Treasury yields rose to minus 0.41 on Dec. 10, its strongest since August 2004, from minus 0.05 at the start of the third quarter. A reading of 1 means they’re in lockstep, while minus 1 means they move in opposite directions.

Since the start of 2013, the loonie’s correlation with Treasury yields increased 0.97, the most among its G-7 peers, excluding the U.S. dollar.

Rising yields in the U.S. make America’s dollar-denominated fixed-income assets more attractive relative to their Canadian counterparts, damping demand for loonies.

 

Widening Spread

U.S. 10-year Treasuries yielded 21 basis points more than their similar-maturity Canadian peers this month, the most since February 2011. Yields on Canadian 10-year government bonds exceeded those of Treasuries as recently as May 16.

“In the past few weeks, the performance of the yield curve has become a big driver for the currency,” Sebastien Galy, a New York-based senior foreign-exchange strategist at Societe Generale SA, said in a Dec. 16 phone interview. “There’s a certain attractiveness to being bearish the Canadian dollar.”

SocGen sees the loonie declining to C$1.10 by the end of 2014. The median estimate of more than 40 economists surveyed by Bloomberg is C$1.08.

The Canadian dollar’s drop versus its U.S. counterpart this year makes it the sixth-worst performer among 16 major currencies tracked by Bloomberg. The loonie hasn’t fallen that much since weakening 18 percent in 2008. One Canadian dollar buys 93.99 U.S. cents. The Canadian currency slipped to C$1.0708 Dec. 6, its weakest level since May 2010.

Bank of Canada Governor Stephen Poloz said on Dec. 12 that the main interest rate may remain unchanged for “quite some time” as policy makers weigh the risk of a drop in housing prices against the threat posed by persistently low inflation. The target rate has been at 1 percent since September 2010.

 

Taper Outlook

In the U.S., 34 percent of economists surveyed by Bloomberg forecast the Fed will reduce its $85 billion in monthly bond purchases at the conclusion of a two-day meeting today. All 35 economists forecast that the start of tapering will take place by March at the latest.

“The Canadian central bank is becoming increasingly dovish as the Fed turns to tapering,” Camilla Sutton, the Toronto-based head of currency strategy at Bank of Nova Scotia, said yesterday in a phone interview. “There’s some divergence at that level.”

Bank of Nova Scotia forecasts the loonie will weaken to C$1.08 by the end of second-quarter 2014. The firm has recommended a “large and building short position,” or a bet the exchange rate will weaken, she said.

 

‘Uniquely Positioned’

Canada’s dollar may see some residual benefits from a U.S. economy that’s expected to improve in 2014, according to UBS AG. U.S. gross domestic product will expand 2.6 percent in 2014, beating the G-10 average of 1.96 percent, according to the median estimate of economists in Bloomberg surveys.

“The Canadian dollar is uniquely positioned to benefit as U.S. growth gathers momentum later next year,” UBS analysts led by Mansoor Mohi-uddin, the Singapore-based head of foreign-exchange strategy, wrote in a Dec. 13 note to clients.

UBS recommends taking a short position on the Australian dollar versus the loonie in the second half of 2014, implying Canadian dollar strength during that period.

Futures show the consensus remains for a decline against the greenback. Traders are the most bearish on the Canadian dollar since the week ended May 3, figures from the Washington-based Commodity Futures Trading Commission show.

The difference in the number of wagers by hedge funds and other large speculators on a decline in the loonie compared with those on a gain, known as net shorts, totaled 57,514 contracts on Dec. 10, the most since May.

“You’re probably going to see the spread between the U.S. and Canadian short-term rates widen out to the dollar’s advantage,” Mark McCormick, a New York-based macro strategist at Credit Agricole SA, said in a Dec. 12 phone interview. “The focus in 2014 is really going to be on what rates do in the United States.”

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