Behind The Scenes: A Look At CAD/JPY

Includes: FXC, FXY
by: Cerebro1

As U.S. Oil recently entered a bull market, now may be a good time to look at the Canadian Dollar.

However given the continued strength of the U.S. Dollar, selling U.S. Dollars for Canadian Dollars is not the right choice.

Investors should consider selling their Japanese Yen for Canadian Dollars.

Behind The Scenes: A Look At CADJPY

While some people like to operate in the limelight, others prefer to work behind the scenes. The introverts versus the extroverts - both can get the work done in their own form and fashion. The bear market in commodities brought some opportunities for investors, one such opportunity is for the Canadian dollar or loonie.

As U.S. Oil prices declined, so did the Canadian dollar as Canada is a major exporter of the product. But with the recent 20% rally in U.S. Oil, the Canadian dollar looks attractive at these current levels. , The extroverted USDCAD (U.S. dollar versus Canadian dollar) may not be the best option given the expected strength in the pair.

It would not be wise to sell your U.S. dollars for Canadian dollars. Investors would need to go behind the scenes, and look for relatively introverted strategies. One such strategy is to buy the Canadian dollar and sell the Japanese yen. This can be seen by going long CADJPY and for investors without Forex accounts, they should consider the ETFs (NYSEARCA:FXC), CurrencyShares Canadian Dollar Trust and (NYSEARCA:FXY), the CurrencyShares Japanese Yen Trust. Investors should consider going long FXC and going short FXY, to replicate the long CADJPY position.

Economic Activity

The Canadian economy has been relatively solid, even as there was a decline in oil prices in the last 8 months. Latest figures show that the Canadian economy grew 1.9% year over year in the November 2014, below the 12 month moving average of 2.3%. The negative impact of lower oil prices will be gradually impacted by stronger U.S. growth, a weaker Canadian dollar relative to U.S. dollars and the beneficial impact of lower oil prices in the global economy.

Chart 1- Canada GDP Y-o-Y (%) as at November 2014

Source: Bloomberg

Chart 2- U.S. GDP versus Bank of Canada's foreign activity measure

The Bank of Canada (BoC) expects Canadian real GDP to slow to about 1.5% in the first half of 2015. Inflation is also expected to fall due to the decline in energy prices and then increase to the target rate in 2016. The BoC expects core inflation to soften in the near term and remain close to 2% over the projected horizon. Canadian CPI rose 1.5% year over year in December 2014 while core CPI increase 1.9%.

Charts 3 & 4- Projections for Core Inflation and Total CPI inflation

A look at Japan shows that the country entered into a recession despite the Quantitative Easing program currently being implemented. Latest figures show that Japanese GDP fell 1.3% in the 3rd quarter of 2014.

Chart 5 - Japan GDP Growth (Year-Over-Year %) as at September 2014

Source: Bloomberg

This was as a result of the consumption tax hike in the middle of 2014. The recession will be compounded with disinflationary pressures as a result of declining energy prices. Japan's core CPI fell to 2.5% year over year in December 2014, down from 2.7% in November. Subtracting the impact from April's sales tax increase, the CPI would have been 0.5%. This is a far cry from the Bank of Japan's 2% inflation target. These disinflationary pressures would cause yen strengthening.

Chart 6 - Japan Inflation (Year-Over-Year %) as at December 2014

Source: Bloomberg

A focus is also required on the extroverted U.S. In its latest FOMC statement the Fed thinks that the U.S. economy is growing at a solid pace. Labor market indicators have improved further as job gains grew and the unemployment rate fell. Household spending is also showing signs of improvement as a result of the decline in energy prices. Businesses have also been investing while core inflation remains low but stable. The Fed thinks that the U.S. economy will continue to expand moderately with improvements in labor market conditions. The tables and charts below show the Fed projections as at December 2014

Table 1 - Economic Projections of Federal Reserve Board Members and Federal Reserve Bank Presidents, December 2014

Source: Federal Reserve

Charts 7- 9 - Central Tendencies Of Economic Projections, 2014-2017 And Over The Longer Run

Source: Federal Reserve

Initial estimates show that U.S. GDP grew 2.5% year over year in the 4th quarter of 2014. This rate is above the 4-quarter moving average of 2.4% so the U.S. is still growing at an above trend pace. Consumer spending was strong as real PCE rose 4.3% versus 3.2% in the previous quarter. This was the strongest quarterly increase in the post-financial crisis era. Residential investment improved given the loosening of mortgage credit and this trend is likely to continue.

Chart 10 - U.S. GDP Growth (Year-Over-Year %) as at December 2014

Source: Bloomberg

This news should bode well for the U.S. dollar, and while the Canadian dollar is also expected to increase, the larger rise in the U.S. dollar will cause USDCAD to increase. Thus, an alternative method is required to take advantage of the Canadian dollar and that is CADJPY.

Trade Idea

Behind the scenes, Oil is a main driver of the Canadian economy thus there is a relationship between, albeit marginal, Oil and the Canadian dollar. The table below shows a 10-Year Weekly correlation matrix between WTI Crude Oil (CLA), CADJPY, Brent Crude Oil (NASDAQ:COA) and the U.S. dollar versus the Canadian dollar.

Table 2 -10-Year Weekly Correlation Matrix of CLA, CADJPY, COA & USDCAD

Source: Bloomberg

CADJPY & CLA has a 0.427 correlation and CADJPY and COA has a 0.405 correlation. Thus the recent 20% move higher in U.S. crude Oil should also have a positive impact on CADJPY and may be considered a trigger for a reversal in the decline of CADJPY.

Another focal point is the diverging global monetary paths. In the euro area and Japan, economic growth has faltered, prompting additional policy stimulus and the expectation of further action.

This contrasts with the expectation of the Fed to normalize monetary policy in 2015 as the U.S. economy continues to strengthen. As such, a short position in USDCAD may not be the best way to benefit from a strengthening Canadian dollar. Investors should consider the Japanese yen, where the current policy calls for a continued increase in money supply, causing a depreciation in the yen. This long CADJPY position can be attained by buying FXC and selling FXY.

Chart 11 - U.S. CADJPY Daily Candlestick Chart as at 6th February 2015

Source: Bloomberg

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.