Commodity price strength and ultralow Federal Reserve interest rates should push the loonie higher in the months ahead but the anti-U.S. dollar speculative fervour may have gone too far in the short term.
The Canadian dollar has rallied about 10 per cent to near 76 US cents since equity markets bottomed on March 23. The primary drivers of the rally are recovering commodity prices that improved Canada’s terms of trade, and extremely low inflation-adjusted U.S. interest rates that make Canadian bond yields more attractive to foreign investors by comparison.
Surprisingly, the Canadian dollar remains a developed world laggard despite the strong rally. In a research note on Sept. 2, Shaun Osborne, chief currency strategist at Bank of Nova Scotia, noted that the loonie is the only developed world currency that has underperformed the U.S. dollar this year, and this is still the case.
The loonie is trading right at Mr. Osborne’s year-end target now and could face some headwinds emanating from the futures market.
Bearish on the greenback
Trade-weighted
U.S. dollar index
CFTC net non-commercial
futures position
US$ (contracts)
105
100,000
100
80,000
95
60,000
90
40,000
85
20,000
80
0
75
-20,000
70
65
-40,000
Sept.
2010
Sept.
2012
Sept.
2014
Sept.
2016
Sept.
2018
Sept.
2020
bullish on copper
CAD/USD
S&P GSCI Copper Index
$0.85
600
0.83
550
0.81
500
0.79
0.77
450
0.75
400
0.73
0.71
350
0.69
300
0.67
0.65
250
Aug.
2015
Aug.
2016
Aug.
2017
Aug.
2018
Aug.
2019
Aug.
2020
john sopinski/the globe and mail,
Sources: scott barlow; bloomberg
Bearish on the greenback
Trade-weighted
U.S. dollar index
CFTC net non-commercial futures
position – US$ (contracts)
105
100,000
100
80,000
95
60,000
90
40,000
85
20,000
80
0
75
-20,000
70
65
-40,000
Sept.
2010
Sept.
2012
Sept.
2014
Sept.
2016
Sept.
2018
Sept.
2020
bullish on copper
CAD/USD
S&P GSCI Copper Index
$0.85
600
0.83
550
0.81
500
0.79
0.77
450
0.75
400
0.73
0.71
350
0.69
300
0.67
0.65
250
Aug.
2015
Aug.
2016
Aug.
2017
Aug.
2018
Aug.
2019
Aug.
2020
john sopinski/the globe and mail,
Sources: scott barlow; bloomberg
Bearish on the greenback
Trade-weighted U.S. dollar index
CFTC net non-commercial futures
position – US$ (contracts)
105
100,000
100
80,000
95
60,000
90
40,000
85
20,000
80
0
75
-20,000
70
65
-40,000
Sept.
2010
Sept.
2011
Sept.
2012
Sept.
2013
Sept.
2014
Sept.
2015
Sept.
2016
Sept.
2017
Sept.
2018
Sept.
2019
Sept.
2020
bullish on copper
CAD/USD
S&P GSCI Copper Index
$0.85
600
0.83
550
0.81
500
0.79
0.77
450
0.75
400
0.73
0.71
350
0.69
300
0.67
0.65
250
Aug.
2015
Aug.
2016
Aug.
2017
Aug.
2018
Aug.
2019
Aug.
2020
john sopinski/the globe and mail, Sources: scott barlow; bloomberg
U.S. efforts to mitigate the economic damage from the pandemic are negative for the currency. By holding interest rates and bond yields well below the level of inflation, and running large fiscal deficits, the Federal Reserve and federal government make dollar-denominated assets less attractive.
Recognizing this, global hedge funds have jumped on the opportunity to short the U.S. dollar. The first accompanying chart compares the trade-weighted U.S. dollar index to the net futures position (bullish futures bets minus bearish bets) for hedge funds as provided by the Washington–based Commodity Futures Trading Commission (CFTC).
The current data show that there are about 6,700 more bearish bets on the U.S. dollar than bullish positions. This is very close to a level that historically has acted as a buy signal for the greenback. In March, 2011; December, 2012; March, 2014; and November, 2017, similar excessive fund positioning was followed by significant rallies in the U.S. dollar.
U.S. dollar strength is, of course, negative for the loonie. A closer look at the main drivers of the Canadian dollar’s value over the past decade uncovers the copper price as the primary indicator for investors to watch now.
The value of the loonie closely tracked relative interest rates – the yield on the two-year Canadian government bond minus the yield on the equivalent U.S. Treasury – for the majority of the post-2009 period. That relationship, however, broke down in early 2018.
At times, the “petro-loonie” nickname reared its head as the domestic currency followed changes in the value of crude. But in the past three years, correlation calculations (the mathematical process measuring the “sameness” of movement in two data series) identify the copper price as almost doubly effective as an indicator for the Canadian dollar in comparison with oil.
The connection with copper has been hugely beneficial for the loonie. The commodity price has hit two-year highs – up 40 per cent from the March lows – thanks to record-setting imports for a quickly recovering Chinese economy.
The second chart underscores how close the relationship has been between the copper price and the loonie, particularly in 2020. Importantly, the copper price is widely used as a barometer of global manufacturing activity and remains sensitive to economic data. A slowing in the postpandemic recovery will have negative effects on the commodity price and because the loonie is tracking copper, it is also a play on a global economic resurgence.
In the short term, investors should not be surprised by a U.S. dollar rally as some of the excessively bearish hedge fund positioning is unwound. In the mid-term, the copper price will likely provide the best indicator for the loonie’s direction.
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Scott Barlow