2023-03-30 11:41:20 ET
Summary
- The Canadian central bank looks poised to cut rates before the US Fed.
- Technically, the USD/CAD is not in a good place right now.
- The Canadian bank has ample FX reserves to support its currency.
There is nothing certain, but the uncertain. - Anonymous
Introduction
The Invesco Canadian Dollar Trust ETF (FXC) is a financial product that provides a cost-effective route for investors to profit from the appreciation of the Canadian dollar in USD terms. Calling the direction of the Canadian dollar is a tricky business as there are quite a few conflicting signals that could tilt things either way. Nonetheless here are some considerations which may help investors who are thinking of a position in this counter.
Things To Note
Twitter
As noted on the Lead-Lag Report Twitter account, the Bank of Canada's endeavors with aggressive monetary tightening (+425bps over eight separate occasions before the March meeting) looks to have made a dent with the inflationary conditions there. The recent reading of 5.2% was not just below street estimates but also was the weakest it has been in over a year.
Already earlier this month, we had seen the Canadian central bank become the first major central bank to signal a pause, keeping overnight interest rates at 4.5%.
In recent weeks we've seen the banking crisis threaten to cause tumult across the world. Some believe the risks may be idiosyncratic but a recent speaker on Lead-Lag Live, Dan Niles, believes there's a lot to unpack and things are unlikely to blow over too soon. Given the linkages that Canadian banks have with their US counterparts, it's only reasonable to expect the Canadian central bank to adopt a cautious stance on account of recent developments.
In fact, the swaps market suggest that there's a 40% probability we actually get a 25bps cut in rates during the next central bank meeting weeks from now. Reuters on the other hand suggests that rate hikes could come further down the line - in July perhaps. Regardless of when this comes, it's been quite a shock because just as recently as March 8 money markets were betting that Canadian policy rates would be hiked again in September (as inflation is still above the bank's 2% target). Needless to say, a cut in policy rates won't reflect too well on the CAD, particularly as the probability of the US Fed doing so does not look too likely in the near future.
Nonetheless, investors would do well to keep track of the yields on two-year Canadian bonds, as changes in central bank policy are more keenly reflected at the short end of the curve, and will likely have a close impact on variable-rate mortgages.
Nonetheless, ongoing appeasement here could do a world of good for Canadian households that are one of the most overleveraged households in the developed world, with debt to disposable income of over 180%!
Another factor that may work against the loonie is the onset of risk-off conditions in the financial markets. A couple of days back I appeared on Real Vision laying down my fears about some potentially damaging conditions in the month of April.
Ideally, a risk-off environment should be good for the US dollar but it doesn't help that the Fed has been quietly expanding its balance sheet and boosting liquidity in the system. This excess liquidity will only erode the value of dollar-denominated assets and that's why you've recently seen a breakdown in the USD/CAD pair after it had appeared to have topped out below the sub 1.39 mark, a level it had previously struggled to clear in October last year.
Taking a broader view we can see that the USD/CAD pair has struggled for firm direction and has broadly oscillated between the $1.33-$1.39 mark. Thus technically, based on this structure, it does appear that the Canadian dollar may offer better value as the price is a lot closer to the upper end of the range.
However, before investors get carried away by the technical imprints, investors also would do well to consider the dim commodity theme in a risk-off environment. In fact, in my chat with Maggie Lake, I've flagged the lingering tail risks associated with commodities that could take on greater weight in the months ahead.
Already this year, the Bloomberg commodity index hasn't gotten off to a great start. If we have a global crisis further down the line that could weigh adversely on commodity demand, thereby damaging the balance of payments position for Canada, which in turn would reflect poorly on the Canadian dollar.
Fortunately, if there are some green shoots to be flagged, I would point to the elevated level of FX resources that the Canadian central bank has managed to build up recently. At almost $109bn it's currently around record levels and could be very useful if the bank needs to undergo any firefighting to support the CAD.
Conclusion
To conclude, there are a lot of conflicting factors that could weigh heavily on the USD/CAD, and rather than expecting a unidimensional one-way move, investors should brace themselves for increased volatility over the next few months.
For further details see:
Invesco Canadian Dollar Trust ETF: About To Get 'Looney'