Canadian dollar outperformance at risk

By Neal Armstrong – Analysis

LONDON (BestGrowthStock) – The Canadian dollar, one of the top performing major currencies this year, looks increasingly vulnerable to overly aggressive expectations for interest rate rises, stretched positioning and a rush of risk aversion.

The currency shot above parity with the U.S. dollar this month, driven by a view Canada would become the first Group of Seven country to raise interest rates, in June, starting a tightening cycle which would see the key rates rise as much as 175 basis points by year-end.

Interest rate hikes would enrich the Canadian dollar’s yield premium against other major currencies, but that advantage is unlikely to last for a long time as other central banks start raising interest rates in the medium term.

“Relative interest rate expectations may be less Canadian dollar-positive later in 2010. This combined with dollar/Canada looking significantly misvalued below parity is why we think it will head higher,” said Aroop Chatterjee, FX strategist at Barclays Capital.

“The base rate is expected to be hiked by about 185 basis points, compared to our estimate for 150 basis points by the end of 2011.”

The latest surge in risk aversion, stemming from concerns that Greece’s debt problem might spill over and hit the banking sector, is likely to prompt more investors to exit.

The Canadian dollar indeed scored its biggest one-day loss against the U.S. currency since October on Tuesday after Greece and Portugal suffered credit ratings downgrades.

“The long Canadian dollar trade is a very crowded one,” said Paul Mackel, director of currency strategy at HSBC.

“The market is moving to risk-off and is spooked by what’s going on in southern Europe. There’s a risk that currencies such as the Canadian dollar will be hit if the debt crisis spreads.”

LOSING MOMENTUM

The Canadian dollar is already losing momentum, having rallied broadly after the Bank of Canada laid the groundwork last week for interest rate rises in June.

It hit a 22-month high against the dollar, while it scored its highest level since 2001 versus the euro. It also hit its highest level since October 2008 against the yen this week.

The result was a drastic increase in bets on the Canada dollar rising. Positioning data on Friday from the CFTC showed Canadian dollar longs already swelling to levels not seen since 2007.

In contrast, short yen positioning remained relatively high, pointing to stretched positions in the pair.

Excessive positioning in favor of the Canada dollar also points to a possibility of a near-term pullback, especially given that the options market is also suggesting risks were skewed to the downside.

Risk reversals for one-month dollar/Canada options, which reflect investor bias toward buying or selling a currency, jumped to 0.85/1.35 in favor of U.S. dollar call options. The levels stood around 0.25 around mid-March, according to ICAP data.

“The risk reversals are showing you traders have a weakness if dollar/Canada rallies. It illustrates the position that the market is most vulnerable to,” said Credit Agricole currency strategist Simon Smollett.

“Technically, in the short term, I see room for a correction, possibly toward channel resistance at C$1.05.”

Stock Analysis

(Graphic by Scott Barber, editing by Nigel Stephenson)

Canadian dollar outperformance at risk