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National Bank of Canada senior economist Krishen Rangasamy believes we've seen the short-term lows for the domestic currency and the loonie is set to rally. Futures positioning and the oil price say he's right.

In a report released Monday, Mr. Rangasamy first acknowledges that the Canadian dollar has been the worst performing major currency in 2017 but then writes, "thanks to today's decision by Saudi Arabia and Russia to extend oil production cuts to next year, the loonie seems to have found some breathing room…. Looking at the record speculative shorts on the Canadian dollar one could argue that, assuming the economy does not implode, it's becoming more and more difficult to top that level of pessimism on the Canadian dollar ..."

The first chart below illustrates how speculative pessimism has reached all-time extremes. The non-commercial net futures positioning (bullish minus bearish futures positions – the data are used as a proxy for global hedge fund trades) published weekly by the Commodity Futures Trading Commission has hit record lows and as Mr. Rangaswamy suggests, little room remains for further downside.

The second chart implies that the loonie is currently undervalued relative to the oil price. The oil price, a central driver of the domestic currency value, has rallied 61 per cent since Feb. 12, 2016, and yet the loonie has climbed only about half a penny against the U.S. dollar for the period.

The economist does see potential hurdles for the loonie in the latter half of 2017, writing, "the C$ could be under renewed pressure over the coming months if, as we expect, incoming data show a sharp moderation in Canadian GDP growth after [the first quarter's] blockbuster performance, there is a relapse for oil prices, and the Fed delivers two additional interest rate hikes before year end."

Slower domestic growth and U.S. Federal Reserve rate hikes would increase the spread between Canadian and U.S. bond yields – a slower economy would push domestic bond yields lower while rate hikes would shove U.S. yields higher. As the third chart highlights, relative yields have been the most powerful driver of the loonie's value in recent years (although not by much more than oil prices).

The recent furor surrounding Home Capital Group likely played a significant role in the recent surge of short positions on the loonie, although this is difficult to quantify. Ask most foreign portfolio managers for the first thing they think of where the Canadian economy's concerned and many will immediately respond "housing bubble" and short positions on domestic banks remain near peak levels. As a result, it's easy to see how the ongoing deterioration of Home Capital has caused a pile-on of short positions in the currency.

Less disastrous news flowing from the real estate sector and stability in crude prices would raise the distinct possibility of a short covering rally in the Canadian dollar in the coming weeks. Short positions are excessive, as noted, and any sign of oil-driven strength in the loonie's value would see speculative traders scrambling to offset this exposure with long biased trades, causing a sharp, if temporary, spike higher for the Canadian dollar.

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