Loonie Strength Not Likely To Continue

There are few considerations for a strengthening U.S. Dollar which will inevitably push commodity prices lower and the Loonie along with it.

1. Economic issues abroad remain unresolved
2. U.S. Economy remains the “lessor of all evils”
3. Continued divergent monetary policy foster a “race to the bottom”
4. Possible U.S. rate hike

European and Japanese economies continue to weaken and while the U.S. isn’t perfect, it is doing OK. Countries will try to stimulate growth in their economies by implementing monetary policy that essentially weakens their currency and makes it “cheaper” on a global scale to do business with them. Given the economic state of Europe, Japan and many other nations, having their currencies strengthen will be catastrophic to their economies as they won’t be able to handle the resulting deflationary forces. It is my belief that while the U.S. is not going raise interest rates, Europe and Japan will have to act to reverse the strengthening of their currencies in order to save their economies. As a result, the U.S. Dollar will strengthen not because of the action (or inaction) of the U.S. Central Banks, but because of the actions of others.

So what does this mean for the Canadian Dollar?

CAD has strengthened because of a recovery in commodities, most notably oil, due to the weakening of the USD. Since commodities are priced in U.S. Dollars, as the currency increases, commodity prices decrease and vice/versa. Note in the chart below the correlation between commodities in general, oil and the CAD (etf FXC) and the inverse relationship to the U.S. Dollar Index. In addition, it is not out of the realm of possibility that we see another Bank of Canada rate cut. Poloz even suggested back in December that if things got really bad, we could see negative interest rates in Canada. Unlikely, yes…but he did mention it.

Daily chart 5/25/2016 – U.S. Dollar Index compared to TSX Composite, CAD, Oil and the U.S. Commodity Index

It is my expectation that global central banks will do everything in their power to weaken their currencies in an attempt to stimulate their economies and that a strong Euro/Yen etc. is unsustainable without having a significant negative impact on their respective economies. The U.S. simply just has to maintain their current interest rate policy and the other central banks will be the catalyst for a USD snap back. Although a weak USD is good for their economy, the world is in a currency war (good book by the way) and it’s a race to the bottom. Based on this expectation, We will likely see a “correction” in the commodity market on the heels of a strengthening USD. We are already seeing the trend change in the USD/CAD chart as indicated below. I suspect that once we finally see oil rollover this trend will only strengthen.

Daily chart 5/25/2016 – USD/CAD

So with all this in mind how do we participate?

I am a firm believer that if you can keep it simple, do it. Based on our bullish USD/CAD outlook, we could buy USX call options. The purchase of the call option allows us to participate in the appreciation of the USD against the CAD with a limited and identifiable risk exposure. These options are European style exercise and are cash settled for the difference between the settlement value and the strike price. You can close your position at any time prior to expiration to cut losses and lock in profits.

Option premiums are quoted in Canadian cents per unit of foreign currency. For example, a premium quotation of 0.75 Canadian cents for an option on the U.S. dollar represents an aggregate premium value of 0.75 Canadian cents / US$ × US$10,000 × C$1/100 Canadian cents = C$75.

For more information please check out USX specifications here.

Which contract?

If we believe that the USD is likely to continue to trend higher for an extended period, we would want to be sure to give the opportunity time to play out. In addition, choosing a longer dated option will also allow us to weather some of the bumps along the way. Since I am suggesting a bullish outlook, we would want to use a Long Call to participate.

Option Type: Call
Strike: 130
Expiration: January 2017
Price: $5.00
Break Even: USD/CAD at $1.35 on expiration

Note that a more advanced trader may want to consider a Bull Call Spread to reduce the cost and break-even point of the position.

In conclusion, trying to forecast the moves of central banks and the impact on a specific currency can be challenging. Often, central bank decisions and the subsequent impact on the market proves to be far from logical. That said, participating as an option buyer allows us to take a decisive directional bias with a limited and identifiable risk exposure. This this strategy can also be implemented in a TFSA or RRSP.