USD/CAD Yield Is More Attractive Than Ever

Includes: FXC, UDN, USDU, UUP
by: Hedge Insider

USD/CAD used to reside in negative-yield territory.

However, more recently, the short-term interest rate differential for USD/CAD is positive, and apparently remaining strongly so.

If the favorable yield differential persists, and provided that oil does not surge too much further, USD/CAD could enjoy plenty of long-term buying interest given the new, positive carry.

There are plenty of factors that move currency exchange rates. One of the most important is interest rates; more specifically, differences in the interest rates of the currencies in question. Even more specifically, short-term interest rates, as these dictate the (short-term) attractiveness of carry trades to traders.

If one currency's yield increases relative to the yields of others, all else equal, that currency should outperform. Of course, "all else equal" (i.e., ceteris paribus) never perfectly applies. But I would like to share one chart which places the USD/CAD pair (the United States dollar in terms of Canadian dollars) on a long-term chart.

USD/CAD Yield Differential

(Chart created by the author using charting tools. The same applies to all further charts presented herein.)

This is a chart using weekly candlesticks to illustrate the price of the USD/CAD pair since around 2009 (the chart illustrates approximately ten years' worth of price data). In addition to the candlesticks for USD/CAD, we also have in green the 1-year interest rate differential (which uses United States and Canadian government bond yields as proxies for the yields of each of the two currencies in question).

The chart shows that the United States dollar suffered against the Canadian dollar for a long time in the first half of this time period. From around April 2009 to the start of 2013, the pair was really going nowhere. During this time period, as shown on the chart, the yield differential was negative, and thus, it is no wonder that the United States dollar looked unattractive. But this started to change from 2013 onward.

The yield differential started to move upward from negative -1% or so (from the time period spanning from around August 2010 to September 2013) to around -0.85% by early 2014 through much of the rest of 2014. The forex market appeared to be very bullish on the dollar. Canada is an oil nation, however, and it is well-known that the currency correlates positively with oil.

Hence, the oil price crash in 2014 (as shown in an updated version of the above chart, below) would have helped support the market in adjusting to a more bullish U.S. dollar with expedience.

USD/CAD and Oil

More recently however, the yield differential between the United States dollar and the Canadian dollar is more positive than ever. And despite some tepidity recently with respect to the United States' ability to weather higher rates (a less ambitious Fed), the interest rate differential currently shows no sign of abating.

Admittedly, this second chart I have presented above does show how oil has recently enjoyed a large surge. However, there is no promise that this will continue. And even if it does, despite this large run-up, notice how the forex market has not decided to sell down the United States dollar; the yield differential has become too attractive.

In other words, while you might think that a surging oil price will be good for the Canadian dollar (and all else equal, it is), not all is equal this time. Now, we have a positive interest rate differential, and this should keep the USD/CAD pair "above water", so to speak. Unless this rate differential crashes, which to this author appears to be unlikely over the medium term, oil will need to be able to surge a lot further in order to affect the USD/CAD pair.

To summarize, USD/CAD is beginning to look like an interesting long-term, positive-carry trade. I believe that the USD/CAD pair may be targeting the levels it last saw as recently as April 2017 (as noted below) at over 1.37.

USD/CAD 1.37 Level

That would compare to the current levels of around 1.33. This is not a high-probability trade idea by any means, as the Canadian dollar is notoriously difficult to trade given the correlation with oil prices. Nevertheless, once again, it is starting to look very interesting. Keep an eye on both yields and oil prices.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.