Canada update – USDCAD view

In the middle of December, when I was asked to give a quick update on USDCAD, I said that I was happy to hold a long position as I thought at that time there was further room for depreciation on commo currencies such as the Loonie (CAD) and the Aussie (AUD).
The fact that the pair first broke its strong support at 1.0600 in the beginning of December last year, combined with the Fed’s decision to start tapering a couple of weeks later ($10bn cut in QE program down to $75bn), both acted in favour of the greenback. USDCAD is now trading at a three-and-a-half year high of 1.0950 (Sept 2009), up by almost 17% from a low of 0.9403 reached on July 2011 (27th).

LT Term view:
If we have a look at the main fundamentals, we can see that the economic situation in Canada has worsened since the Great Financial Crisis. First of all, as many analysts/strategists mentioned it lately, the country’s current account (as a share of GDP) has plummeted from a 1% surplus in Q3 2008 to a 3.0/3.5% deficit in early 2010 and has remained steady since then. We know that when a country runs large current account deficits for several years, it tends to put downward pressure on the exchange rate.
Moreover, with an annual inflation that printed at 0.9% in November, slightly below the BoC range of 1.0% – 3.0%, investors and traders are speculating that the central bank will either introduce an easing bias or decrease its overnight lending rate (currently at 1.0%) in order to stimulate the economy.

The graph below represents the 2-year CAD-US yield spread (reversed legend, white line) and the USDCAD spot rate (yellow line). If the spread continues to fall due to a drop in Canadian ST rates (30bps drop since mid-September last year), carry traders will lose their interests in the Loonie, acting in favour of USDCAD (1.1200 looks like a good level to me in the medium term).
As you can see it, since mid-September 2012, the spread (CAD-US) has narrowed by almost 40 bps (trading at 0.6464% at the moment) while USDCAD strengthened from 1.0280 to 1.0950.

(Source: Bloomberg)

Short term:
The pair has been fluctuating within a narrow range (around 1.0950) for the past few days, as traders are waiting for the Bank of Canada’s decision on the overnight rate with the publication of the quarterly Monetary Policy Report (MPR) on Wednesday. We don’t expect sharp moves on USDCAD until the monetary policy meeting; however the pair can continue its bullish momentum in the short term in case of a dovish statement. The next resistance on the topside stands at 1.10.

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