CAD: Rally at Odds with Fundamentals CAD: Rally at Odds with Fundamentals CAD: Rally at Odds with Fundamentals

CAD: Rally at Odds with Fundamentals

Forex 6 minutes to read
Charu Chanana

Head of FX Strategy

Key points:

  • Sharp Gains in CAD: The Canadian dollar has surged nearly 3% against the US dollar in August, driven by a dovish shift in the Fed outlook and potential short covering by traders who had record short positions.
  • Record Short Positioning: The rally has been partly fueled by short covering, as traders unwound their positions amid the weakening USD, adding momentum to the CAD’s gains.
  • Fundamentals Suggest Weaker CAD Ahead: The Bank of Canada’s expected aggressive rate cuts and deteriorating economic outlook could undermine the CAD. Worsening yield differentials, potential USD correction, and technical oversold conditions suggest that current CAD gains might not be sustainable.

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Why is the CAD Rallying?

Fed’s Rate Outlook

At the Jackson Hole conference, Federal Reserve Chair Jerome Powell hinted that rate cuts might begin as early as September, with a particular focus on the worsening labor market. He also left the door open for a potential 50bps cut, which has significantly weakened the USD. This has fueled gains across all G10 currencies, including the CAD. Since early August, when the U.S. July jobs report bolstered the case for Fed easing, the USD has experienced notable weakness. Although the CAD has benefited from this, it still trails behind other G10 currencies.

Short Covering

The CAD rally is partly driven by a wave of short covering. Positioning data from the Commodity Futures Trading Commission (CFTC) indicates that the net short position in Canadian dollar futures may have reached record levels in late July. Traders had heavily shorted the CAD, anticipating a divergence between the easing cycles of the Federal Reserve and the Bank of Canada. The BoC has already cut rates twice this year and is expected to continue easing, while the Fed’s actions were seen as more uncertain.

However, as the U.S. dollar weakened and the CAD began to rise, these short positions became increasingly untenable. Traders who bet against the CAD were forced to unwind their positions, leading to a sharp reversal. This has been evident in the CFTC positioning update for the week of 20 August where net short positioning in CAD dropped from $14bn in the week of 30 July to $12bn. This process, known as short covering, has added considerable momentum to the CAD’s recent strength.

Higher Oil Prices

Rising oil prices are boosting the loonie, thanks to Canada's substantial oil export revenues. This week, crude oil has gained fresh momentum due to escalating tensions in the Middle East and potential supply disruptions in Libya. Additionally, the Fed’s rate cut outlook has led markets to anticipate that US demand won't collapse.

 

Risks to the Rally

Bank of Canada’s Rate Cuts

The Bank of Canada (BoC) may cut rates more aggressively than expected. The market anticipates the BoC will lower its benchmark rate to 4.25% in September, with further reductions potentially bringing it to 3% by next July. Such cuts could undermine the CAD’s rally by narrowing yield differentials.

Technical Indicators Pointing to Oversold Levels

USDCAD is trading far below its 200-day moving average. The bearish tone has seen the USDCAD pair hit lower lows and breaking below its lower Bollinger Band, pushing deeper into oversold territory. This technical setup suggests the potential for a correction or at least a pause in the rally.

Source: Saxo. Disclaimer: Past performance does not indicate future performance.

Risk Taking Could Remain Limited

With ongoing global uncertainties, risk appetite could remain subdued, limiting the loonie’s upside potential. Concerns about global economic growth, geopolitical tensions, and the Fed's monetary policy could make investors cautious, dampening demand for risk-sensitive assets like the CAD.

Scope for USD Correction

The CAD has lagged in month-to-date gains against the USD, and the recent USD selling may have gone overboard. With the USD looking structurally cheap amid lingering geopolitical uncertainties, weaker global growth prospects, and the uncertain outlook for the US elections, a USD recovery could hurt the CAD. Yield differentials suggest that the CAD could be the most vulnerable currency in the G10 FX space if the USD strengthens.

 

What to Watch

  • Canada’s Payroll Employment Report (Thu): This report will offer insights into Canada’s labor market, a crucial factor for BoC rate decisions. Watch for any signs of moderating wage growth alongside headline job growth, as this could influence BoC's policy trajectory.
  • Canada’s GDP Data (Fri): The GDP data will be critical in assessing the health of the Canadian economy and will impact both BoC policy and CAD performance. A significant miss on Q2 GDP growth could increase pressure on the BoC to consider a larger (50bp) rate cut, although such a move remains unlikely given ongoing inflation risks.
  • US Data Releases: Key U.S. economic reports, including PCE (Aug 30) should be closely monitored for potential shifts that could affect USDCAD.


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