The news of the OPEC deal triggered a knee-jerk rally in CAD. The news of the agreement took markets by surprise, leading to a nearly two big figure drop in USDCAD during the session. Our reaction has been to fade the rally in CAD, however.
For one thing, there is plenty of uncertainty about the details of the deal, suggesting that the oil rally could fade. With the particulars of the deal still murky, this leaves the market a couple months to question the legitimacy and execution of the deal. For another, while oil prices have been important for the daily wobbles in USDCAD the recent focus has shifted back to domestic issues. Growth, for instance, continues to track below the BoC’s forecasts. This implies another forecast downgrade at next month’s MPR. Our high-frequency growth tracker shows the economy barely growing above 1% over the past three months. Given the widening of the output gap, core inflationary pressures should continue to moderate. The trade numbers show that the economy continues to grapple with structural issues and the currency remains overvalued. Indeed, the current account deficit sits at cyclical lows around 3.36%, which is nearly 200bp from the sustainable rate. This dynamic has occurred despite the 26% drop in the REER level, implying structural competitiveness issues. The exchange rate remains part of the rebalancing process. The combination of these cyclical and structural factors has seen the BoC downgrade its inflation profile. With the BoC now in play, this increases CAD’s sensitivity to data surprises.
We think these domestic risks and our Fed outlook favor further upside in USDCAD. Our year-end call remains 1.35. We also note that market positioning probably played a decisive role in the USDCAD plunge. Our read of macro positioning suggests that long USDCAD was one of the most overcrowded trades in the leveraged community. Many have been short since the BoC downgrade the inflation language in the last statement, probably positioning for a shift in the odds of a rate cut over the coming months.
Our high-frequency fair value model showed that valuations were stretched, increasing the potential for a minor correction in USDCAD. We believe this has led to some stale longs in the pair, with the OPEC news providing the trigger for the squeeze.
Looking ahead, we prefer holding long USDCAD exposure into the monthly GDP report tomorrow and expect brief and shallow dips in USDCAD into the yearend. A convincing break of the 1.314 level opens up a test of the recent highs near 1.33.
Finally, we also believe that increased tensions in the European banking system and other idiosyncratic risks this quarter favor defensive strategies, which support strategic shorts CAD against both the USD and JPY in Q4.
Copyright © 2016 TD Securities, eFXnews™
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