Forex Investment and Currency Trading

A lot happened over the last two weeks but the net result is USD/CAD is merely 0.8% lower over the period as the clearing of CAD shorts during the first week left was followed by a move higher in USD broadly this week. The stability of USD/CAD within the recent volatile ranges, however, masks CAD broad outperformance: over the past two weeks CAD was the strongest G10 currency, rallying as much as 4% versus funding FX and upwards of 2% versus all the european currencies, including a 2.8% to fellow commodity-currency NOK.

CAD strength is in large part attributable to a choppy but notable rally in USD over the past two weeks and a sharp pricing-out of worst-case-scenario growth outcomes in the US. With CAD having traded in synch with a struggling USD over the past several weeks on perceptions of more direct vulnerability in Canada from a US recession, it is plausible that a similar pattern would develop on a USD bounce. Beyond recent price-action, however, domestic developments in Canada this week were far from negligible. The 50bps from the BoC on April 22 was essentially fully priced and had little FX impact beyond a knee-jerk bout of CAD selling that corrected within a few hours. More significant were aspects of the accompanying statement and, more crucially, the revised projections and overall tone of the BoC’s Monetary Policy Report released on April 24. On the growth side, the net result of forecast revisions was a cut to 0.6% (from 1.3% in the January MPR) for 1H08 real growth - with a sharp correction down to 0.3% from 2% prior in the 2Q08 forecast; total 2008 and 2009 annual growth estimates were also revised lower.On the inflation side 2008 headline estimates were revised higher (to 1.8% from 1.5%) while core projections were tweaked lower. The economists’ take on the BoC’ policy stance post-MPR is that they are maintaining a clear easing bias. Market anticipates that weak growth and below target core inflation will prompt the BoC to ease further, cutting the policy rate to 2.50% by July 2008, before going on hold.

Base case for monetary policy, in and of itself, suggests CAD should remain a laggard among G10 FX. However, price action this week suggests caution against the reliability going forward of this relative macro-divergence theme. Sharp moves at the front end of the yield curve were the key drivers of FX movements this week; CAD and other currencies that have traded at a significant risk premium in recent months (USD being the starkest example) benfitted most from the unwind of the curve steepening trades. Over the past week, 2-year swap yields have jumped 30bps in the US and 10bps in Canada. The rise in 2-year Canadian yields is all the more impressive against the backdrop of the Bank of Canada decision to cut rates. While the possibility that the intense US data calendar will bring focus back to US weakness and weigh on CAD in turn, any sign from the Fed that the easing cycle is over would likely be the key (CAD and USD bullish) driver.