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Why is the Canadian Dollar So Strong?

By , Quantitative Strategist
27 April 2012 23:31 GMT
Why_is_the_Canadian_Dollar_So_Strong_body_Picture_5.png, Why is the Canadian Dollar So Strong?Why_is_the_Canadian_Dollar_So_Strong_body_Picture_6.png, Why is the Canadian Dollar So Strong?

Fundamental Forecast for Canadian Dollar: Bullish

The Canadian Dollar surged to fresh 7-month highs against the US Dollar as disappointing US economic data sent the Greenback sharply lower across the board. A relatively empty Canadian economic calendar did little to slow USDCAD losses, and the coming week promises much of the same on modest event risk. All eyes remain on the US calendar on a busy week of data for the world’s largest economy; trends point to fresh Canadian Dollar highs against its southern neighbor.

Why is the Canadian Dollar so strong? The answer is simple: yields. Traders continue selling the US Dollar as US interest rates and Treasury yields are at or near record lows, and most expect rates to remain “exceptionally low” though the foreseeable future. Canadian interest rates and yields are likewise low by historical standards but still noticeably above those in the United States. A glance at 3-month Government bonds show Canada debt pays near 1.00 percentage point more in yields than US 3-month T-Bills (0.08%!). What’s the net result? Investors do not want to hold US Dollars and would prefer to hold Canadian Dollars if they can help it. Further compounding the effect, interest rate traders predict that the Bank of Canada will be the only G10 central bank to actually raise rates through the foreseeable future.

Can the Canadian Dollar continue to gain? The answer is less straightforward. Investors do not want to hold US Dollars if they can earn higher returns on their capital in Canada or elsewhere. Yet this assumes that financial markets remain relatively stable, and there is no risk of major currency exchange rate moves. Currency options traders predict that near-term volatility will remain very low—boosting outlook for the Canadian Dollar. Yet things can and do change quite rapidly, and a major shift in market dynamics could alter the trajectory of the US Dollar and the USDCAD pair.

We won’t go against the prevailing trend, and indeed there seem to be fundamental reasons to stay short the USDCAD. But watch for any major surprises in upcoming US economic data. Such periods of low volatility breed financial market complacency, and any major shocks to the system can wake up investors in a hurry. Keep an eye on moves in the US S&P 500 as a barometer for broader investor risk appetite. If we continue to see the S&P trade near multi-year peaks, expect the USDCAD to trade noticeably lower. - DR

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27 April 2012 23:31 GMT