Canadian Dollar: Positioning Stretched!

After reaching a 12-month high at the end of last year, the Canadian Dollar has been weak throughout 2024 (-4.5% YTD). That largely reflects the shift in US rate expectations this year. Over recent weeks, one-year spreads (Canada - US) have widened sharply to -0.87pp (fig 1a) as the US has priced out rate cuts, and Canada has begun its rate cutting cycle (with a 25bps cut at its latest policy meeting). Historically the interest rate differential (with US rates) has been a key driver of the USDCAD exchange rate.

Historically, oil prices have also been highly correlated with the USDCAD exchange rate. However, this correlation appears to have been broken since mid-2023. Oil prices have increased by 7.3% YTD (fig 1b), while the Canadian Dollar has moved in the opposite direction.

For now, a cut is not priced in for the next policy meeting by the Bank of Canada in July, suggesting that further data on inflation dynamics are needed to determine the speed at which rates will be cut. With that being said, markets are anticipating two rate cuts by the October meeting. In contrast, rate cuts are being priced out in the US. This divergence in monetary policy expectations has added to the volatility and uncertainty surrounding the CAD.

From a market positioning perspective, though, high levels of bad news (bearishness) are already priced into the outlook for the CAD. Speculators are currently net SHORT 138,000 contracts (fig 1), the highest level on record. The extent of these net SHORT positions, highlights the limited room for further currency weakness and the growing risk of a short covering rally (perhaps on a sharp change in the policy outlook). With that, we keep our eyes on US & Canadian macro, both inflation and growth data.