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Merrill Lynch foreign exchange strategist Ben Randol notes that global hedge funds are rapidly selling their bullish bets on the Canadian dollar and retail investors could soon join the trend, setting the stage for a sharply lower loonie to begin 2018.

In a Dec. 15 report, Mr. Randol writes, "hedge funds and real money now appear to be in the process of selling out of extended CAD longs … We think that this represents an important directional shift." He believes this loonie-selling process will end with the domestic currency at 75 cents (U.S.) early next year.

The first chart below illustrates speculative futures positioning in the Canadian dollar. The Commodity Futures Trading Commission publishes a weekly report showing long, short and net positions in a wide variety of futures markets, including currencies. (Net positions are long futures bets minus shorts.) The "non-commercial" sections of the report are used as a proxy for hedge fund trades.

Both the total number of long contracts (the salmon-pink line) and the net positioning have changed dramatically in the past six months. In the case of the net position, it has moved from negative 99,000 contracts near the end of May – there were about 99,000 more futures trades betting on the loonie falling than rising – to positive 76,392 by Oct. 10. During the same period, total long position contracts jumped by about 73,000 contracts to more than 97,000.

Speculative bullishness on the domestic currency has fallen sharply in recent weeks, however. Total long futures positions have declined by more than 40,000 contracts since the end of September and the net position is down more than 32,000 contracts from the peak.

Merrill Lynch cites diverging central bank policy as the reason to expect weakness in the loonie. December, during which the Federal Reserve raised interest rates and the Bank of Canada left domestic policy unchanged, is the beginning of a trend that will see U.S. rates climb steadily while Governor Stephen Poloz stands pat as he assesses a slowing Canadian economy.

The second chart shows why monetary policy is so important for the loonie. Short-term bond yields rise with central bank policy rates, and the relative yields on U.S. and Canadian bonds has been the primary determinant of the Canadian dollar's value versus the greenback in recent years.

The salmon-pink line on the chart represents the yield spread – the yield on the two-year government of Canada bond minus the yield on the two-year U.S. Treasury. This spread has moved extremely closely with the Canadian dollar's price in recent years.

Mr. Randol's forecast is that the Federal Reserve will be more aggressive than the Bank of Canada in raising interest rates, which will push U.S. two-year bond yields higher relative to Canadian bonds. This will cause the pink line on the chart, and the loonie (purple line), to fall.

Weakness in the Canadian dollar, however, is only expected to be temporary. Merrill Lynch predicts that both domestic and U.S. central banks will increase interest rates three times before the end of 2018 – it's just that the Fed will be more aggressive in the first half of the year.

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