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Shorting the loonie remains a popular trade among global hedge funds but it’s difficult to see why. The domestic currency looks fair-to-undervalued relative to the main relevant forces of bond yields and the oil price.

Most signs point to a removal of short positions in coming weeks and a possible spike in the Canadian dollar.

The Washington-based Commodity Futures Trading Commission (CFTC) publishes weekly data on futures positioning in the variety of currencies including the loonie. The “non-commercial” section of the weekly CFTC report is used as a proxy for hedge funds and other speculative investor bets in futures and options markets.

Futures positioning for the loonie is shown in the first chart. The “net position” is simply the number of contracts betting on a higher Canadian dollar minus those betting on a lower loonie. The current reading is minus 42,236 contracts, which means that in aggregate, the number of hedge fund contracts shorting the loonie exceeds the number of contracts aiming to benefit from a rising domestic dollar by more than 42,000.

A SPIKE IN THE LOONIE COMING?

CAD/USD (left scale)

CAD/USD: CFTC non-commercial net futures

position (right scale, thousands of contracts)

$1.00

100

80

0.95

60

40

0.90

20

0.85

0

-20

0.80

-40

0.75

-60

-80

0.70

-100

0.65

-120

2014

2015

2016

2017

2018

2019

CAD/USD (left scale)

Two-year spread: Two-year Canadian bond

yield minus two-year U.S. Treasury yield

(right scale, %)

$1.00

0.9%

0.7

0.95

0.5

0.90

0.3

0.85

0.1

-0.1

0.80

-0.3

0.75

-0.5

0.70

-0.7

0.65

-0.9

2014

2015

2016

2017

2018

2019

CAD/USD (left scale)

Western Canada Select crude

(right scale,US$/bbl)

$100

$1.00

90

0.95

80

0.90

70

60

0.85

50

0.80

40

30

0.75

20

0.70

10

0.65

0

2014

2015

2016

2017

2018

2019

CARRIE COCKBURN / THE GLOBE AND MAIL,

SOURCE: BLOOMBERG, SCOTT BARLOW

A SPIKE IN THE LOONIE COMING?

CAD/USD (left scale)

CAD/USD: CFTC non-commercial net futures position

(right scale, thousands of contracts)

$1.00

100

80

0.95

60

40

0.90

20

0.85

0

-20

0.80

-40

0.75

-60

-80

0.70

-100

0.65

-120

2014

2015

2016

2017

2018

2019

CAD/USD (left scale)

Two-year spread: Two-year Canadian bond yield

minus two-year U.S. Treasury yield (right scale, %)

$1.00

0.9%

0.7

0.95

0.5

0.90

0.3

0.85

0.1

-0.1

0.80

-0.3

0.75

-0.5

0.70

-0.7

0.65

-0.9

2014

2015

2016

2017

2018

2019

CAD/USD (left scale)

Western Canada Select crude (right scale,US$/bbl)

$100

$1.00

90

0.95

80

0.90

70

60

0.85

50

0.80

40

30

0.75

20

0.70

10

0.65

0

2014

2015

2016

2017

2018

2019

CARRIE COCKBURN / THE GLOBE AND MAIL,

SOURCE: BLOOMBERG, SCOTT BARLOW

A SPIKE IN THE LOONIE COMING?

CAD/USD (left scale)

CAD/USD: CFTC non-commercial net futures position (right scale, thousands of contracts)

$1.00

100

80

0.95

60

40

0.90

20

0.85

0

-20

0.80

-40

0.75

-60

-80

0.70

-100

0.65

-120

2014

2015

2016

2017

2018

2019

CAD/USD (left scale)

Two-year spread: Two-year Canadian bond yield minus two-year U.S. Treasury yield

(right scale, %)

$1.00

0.9%

0.7

0.95

0.5

0.90

0.3

0.85

0.1

-0.1

0.80

-0.3

0.75

-0.5

0.70

-0.7

0.65

-0.9

2014

2015

2016

2017

2018

2019

CAD/USD (left scale)

Western Canada Select crude (right scale,US$/bbl)

$100

$1.00

90

0.95

80

0.90

70

60

0.85

50

0.80

40

30

0.75

20

0.70

10

0.65

0

2014

2015

2016

2017

2018

2019

CARRIE COCKBURN / THE GLOBE AND MAIL, SOURCE: BLOOMBERG, SCOTT BARLOW

The average net position over the past five years is minus 13,500 contracts, so fund managers are currently a lot more bearish on the loonie than usual.

The pessimism appears unsupported, unless, like fund manager Steve Eisman’s high-profile short position in domestic banks, hedge fund managers are betting on potential housing market-related credit stress here – using the currency rather than bank stocks.

The second accompanying chart shows the important role bond yields have played in determining the value of the loonie. The blue line on the chart depicts what is called the two-year spread – the Canadian two-year government bond yield minus the two-year U.S. Treasury bond yield.

Correlation calculations confirm what we see on the chart – the domestic currency has closely followed the two-year spread over the past five years. (The tight relationship is a function of cross-border asset flows. When Canadian bond yields are higher than U.S. yields, international fixed income investors move more funds into Canada to buy them, creating a bid for the Canadian dollar in currency markets.)

Based on the scale used on the chart, the loonie seems slightly overvalued relative to bond yields but within a range that suggests fair value.

The currency has also moved with the Western Canadian Select crude price, although correlation analysis indicates the relationship is not as strong as with relative bond yields. In the third chart, a divergence is apparent but it’s not one that supports a short position on the dollar.

The two lines, which historically move closely together, are now wide apart in a way that implies the loonie is undervalued relative to the oil price, and likely to move higher to reflect the higher crude price.

There is also the important point that Canadian economic data – including new jobs created, wage growth, housing starts and retail sales – have been coming in well above expectations. This puts upward pressure on two-year bond yields (or at least limits the downward pressure resulting from volatile equity markets), and moves the two-year spread in the direction that pushes the loonie higher.

Central bank policy expectations also favour a stronger domestic currency. Wednesday’s Bank of Canada statement on monetary policy outlined a decidedly neutral position with little chance of a near-term change in domestic interest rates. In the United States, however, derivative markets imply an 80-per-cent probability of a rate cut by the end of 2019, according to Bloomberg.

A stable Canadian rate environment, combined with a rate cut by the Federal Reserve, would push U.S. bond yields lower relative to domestic yields. This would force the blue line on the second chart upward, supporting a higher loonie.

Based on the available evidence, the hedge funds shorting the Canadian dollar have little reason to be doing so. I strongly suspect that these short positions are being unwound, a process that will put more bids on the loonie in foreign exchange markets, and the next few CFTC data reports will show a much more optimistic view on the Canadian dollar.

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