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-Paul Chiasson/The Canadian Press

Traders are positioning themselves for what could be the last leg down in the Canadian dollar's three-year collapse.

They're paying the biggest premium since September for options contracts that protect against currency swings expiring a month from now than for similar contracts that expire three months out, as oil suddenly threatens to fall below $40 (U.S.) a barrel again and the U.S. Federal Reserve looks set to raise interest rates in a matter of weeks. The last time the premium for 30-day protection spiked this high the currency ended up falling to an 11-year low before month's end.

The options market is lining up with the consensus forecast of economists, who also see weakness in the short term followed by stabilization and ultimately gains into 2016. For many, the Fed's first interest-rate increase in almost a decade and the most recent surge in oil inventories could mark the last stage of the loonie's 25-per-cent, three-year slide.

"That's going to be the trough for the Canadian dollar," Krishen Rangasamy, senior economist at National Bank Financial Inc., said in a telephone interview from Montreal. "We're now closer than ever to a Fed hike and if you look at history, when the Fed starts hiking rates, the U.S. dollar doesn't do well, because it's already priced in. The option market is thinking like us."

The premium for one-month volatility options against the U.S. dollar compared to three-month contracts surged to 77 basis points, or 0.77 of a percentage point, last week, the most since Sept 2. On Sept. 29, the loonie fell to $1.3457 per U.S. dollar, or 74.31 cents (U.S.), its lowest level since 2004.

At the same time hedge funds and other speculators are boosting their bets against the Canadian dollar by the most in almost four months. New wagers for the currency to fall against its U.S. peer outnumbered those for it to gain by 10,445 positions the week ended Nov. 17, the biggest seven-day surge in net-short positions since July, according to data from the U.S. Commodity Futures Trading Commission.

Forecasters see the Canadian dollar weakening to $1.35 per U.S. dollar in the first three months of next year, and then strengthening to $1.32 by year end, according to the median estimate of a Bloomberg survey. The loonie closed Monday at $1.3373 per U.S. dollar, or 74.78 cents (U.S.).

Fed, oil

The catalyst for the next leg down both options traders and economists have their eye on is the Fed, which has signalled it could raise its benchmark interest rate from near-zero as early as its Dec. 15-16 meeting. So far this year speculation the U.S. would raise borrowing costs has already been enough to lure capital looking for higher yields south. Combine that with a supply glut that's renewed downward pressure on crude-oil prices, one of Canada's biggest exports, and the two main factors that have driven the currency down the past two years look to be coming to a head once more.

"There is potential for a big drop in December," Greg Anderson, global head of foreign-exchange strategy at Bank of Montreal, said by phone from New York. "We don't need to drop lower in oil, we just need to hang here, and if we do that's probably a negative for the Canadian dollar that has not been fully priced in. And then there's the Fed rate hike."

Mr. Anderson sees the Canadian dollar's trough lasting longer – stretching through a second Fed rate increase he's calling for in March that'll put the U.S. benchmark interest rate above Canada's for the first time since 2007 – and removing the small remaining yield benefit investors might have had holding the loonie. By the end of 2016 he predicts the currency will stabilize.

"I do think we're near the end," he said.

Last gasp

History also suggests the arrival of higher rates in the U.S. could mark the end of the loonie's rout.

An index tracking the greenback against 10 major peers strengthened an average of 9 per cent during the six to nine months before the past three Federal Reserve rate-rise cycles, according to data compiled by Bloomberg. After the increases actually got under way it was a downhill ride, with the six-month drop in the U.S. dollar against everyone else averaging about 6 per cent.

For David Rosenberg, chief economist at asset manager Gluskin Sheff + Associates, the wild card the market is most worried about is oil, with U.S. stockpiles persisting above historical averages longer than anyone expected.

"That's why you have that protection," he said by phone from Toronto. "It's really about the view the Canadian dollar could have another down leg here."

Mr. Rosenberg still senses the great depreciation's last gasp, and predicts the currency strengthening to 76.92 cents in about six months.

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