Is USD/CAD Still Attractive?

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

While USD/CAD recently looked very attractive from a bullish perspective, the carry on this currency pair had unfortunately broken down.

Although the carry on USD/CAD remains positive, it is close to zero, and thus the bullish thesis no longer appears so strong, at least for the time being.

If U.S. and Canadian rates stabilize, and if oil prices begin to drop once again, USD/CAD could surge higher (since its carry remains positive).

However, if sentiment and guidance on U.S. rates remains dovish (at least in the short term), and/or if oil prices surge higher, the Canadian dollar will instead look like an attractive buy.

In any case, in the immediate term, a warning signal for Canadian dollar bulls lies in the ratio between the S&P/TSX Composite and the S&P 500. The ratio has recently plummeted; if you are still short USD/CAD, you may want to ease out of that trade and take profits.

In my article entitled USD/CAD Yield Is More Attractive Than Ever, I observed that the interest rate spread on certain shorter-maturity government bonds (as they relate to the USD, or United States government bonds; and CAD, or Canadian government bonds) was "more attractive than ever".

By this, I meant that it appeared to make a lot of sense to buy the USD/CAD pair, due to the positive carry. If you had acted on this logic, you would have made money. However, a belated update is in order, as this trade idea depended on watching the relevant interest rate spread. The spread has since broken down, as we can see in the chart below:

USD/CAD Pair Breakdown (Chart created by the author using The same applies to all subsequent charts presented herein.)

The chart depicts the USD/CAD pair's price using daily black-and-green candlesticks, with the blue-shaded area depicting the net-positive interest rate spread with respect to two-year United States government bond yields minus two-year Canadian government bond yields.

The first black line was the date on which my previous article on USD/CAD was published; April 10, 2019. Subsequently, the pair rose as high as 1.35214 (over 1.50%) from the close of April 10, 2019. Unfortunately, however, it became apparent by 26 April, 2019 (depicted using the red vertical line in the chart above) that the once favorable yield differential on this pair had begun to break down.

As we can see, this continued to break down, yet it was not until the beginning of June 2019 this month that we actually saw the pair break down along with it. (An eager watcher of global rates would have been able to exploit this divergence by entering a short USD/CAD trade.) This divergence is apparently continuing, which would suggest more pain is in store for USD/CAD.

USD/CAD vs. US Oil Per the chart above, if we invert USD/CAD (to form CAD/USD), and overlay the US WTI oil price, we also get a glimpse of perhaps why it took so long for the United States to weaken against the Canadian dollar. The Canadian dollar is positively correlated with oil prices, due to the country's exposure to oil (it is sometimes referred to as an "oil currency", similar to the Australian dollar).

Fortunately for the Canadian dollar, oil prices now seem to have found a short-term bottom. If the rate divergence continues and/or oil prices are able to continue to stabilize (or proceed even higher), USD/CAD would be positioned to fall further. Watching these changes on a rolling daily basis is important to ensure you are not trapped on the wrong side of any trade.

However, I do not recommend buying the Canadian dollar and going short the United States dollar (or in other words, going long USD/CAD). Why? A red flag is flashing on my radar: the ratio between a popular Canadian equity index, the S&P/TSX Composite, and the United States' counterpart the S&P 500, has recently dropped sharply. (See the chart below.)

TSX Composite vs. S&P 500 As you can see, the ratio was rising into the recent CAD/USD spike (i.e. Canadian equities were in increasing demand, which helped to buoy the demand for the Canadian dollar, helping to produce the recent spike in the Canadian dollar). Now, the ratio is breaking down. This could trigger a pullback in the Canadian dollar.

This risk of a pullback would increase further if oil prices fail to go higher, and/or if the rate spread (U.S. bond yields minus Canadian bond yields) drives lower. As can be seen in the first chart of this article, the interest rate spread on two-year bonds (U.S. vs. Canada) is still positive at about +0.46%. Yet this is close enough to zero to shake the attractiveness of the trade (which is unfortunate for the U.S. dollar).

In other words, the United States is relatively speaking now far less attractive than it was when I wrote about USD/CAD in early April. Yet things could reverse once again if rates and oil stabilize, and if my equity-index ratio signal (outlined above) serves us well.

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.