FX Traders Fall in Love with Loonie as Canada Goes to the Polls

(Bloomberg) — Currency traders are a little tense about Canada.

As voters prepare to cast their verdict on Prime Minister Justin Trudeau’s government in the polls on Monday, the market has a decidedly bleak picture of the local currency, despite the recent rebound in commodity prices. In fact, the rise in global commodity costs could become a headwind for the country’s economy rather than a tailwind, as domestic inflation concerns are at the heart of citizens, politicians and central bankers alike.

The madman, as it is affectionately known for the bird that graces Canadian coins, was one of the developed market’s worst-performing currencies in the second half of this year. After surpassing all of its Group of 10 counterparts in the first six months of 2021, it is down 3.6% since June 30. pave the way for a tightening of monetary policy.

“It’s been pretty clear over the past two weeks that the CAD just isn’t responding to some of the positive fundamentals as we expected,” said Shaun Osborne, chief foreign exchange strategist at Scotiabank. “I suspect the CAD may continue to struggle a bit.”

On Monday, the loonie was the second worst-performing G-10 currency amid a broad decline in stocks and commodities as investors weighed in on the impact of China’s struggling real estate sector.

In the options market, the right to sell the Canadian dollar against the dollar has increased in price relative to the price of the purchase rights in three months’ time. So-called risk reversals, which compare the costs of these puts and calls, reached levels unseen since June 2020 this month, indicating increased interest in hedging against losses in the Canadian dollar.

Data from CME Group shows traders have built a fictitious portfolio of more than $50 billion in low-delta Canadian dollar put options on strikes at C$1.33 per dollar, further sign of concern over the loonie’s weakening from current levels near C$1.28. Implied one- and three-month volatility measures have risen in recent weeks, suggesting some investors are bracing for an increase in activity.

Positioning data from the Commodity Futures Trading Commission also shows that the Canadian dollar is making a bullish comeback. While speculators maintain a net long position, it has fallen significantly since the recent peak in mid-July, while asset managers also hold smaller bullish positions than a few months ago.

All of this comes even as the Bloomberg Commodity Index is up 2% since June 30, even though crude oil is down about 4.2%.

Polls in Canada have shown that Trudeau’s liberals are fighting hard to stay in power, despite promises to increase spending. While elections have not typically been a source of major investor turmoil when it comes to Canada, there are a number of elements in this year’s battle between Trudeau and conservative challenger Erin O’Toole that could affect markets.

The biggest risk will be if a minority government is formed that can’t move forward with policy decisions, potentially leading to new elections in the not-too-distant future, according to Toronto-Dominion Bank analyst Mark McCormick. This could lead to increased volatility in the short term, he said.

Trudeau has a small electoral advantage, with help from his opponents

Another important potential effect is on the background of monetary policy. The central bank’s five-year inflation-targeting mandate is due to be renewed this year, and there’s a chance Bank of Canada Governor Tiff Macklem will ask for more flexibility, so whoever is in power may hold the key to that.

Inflation target

O’Toole has said he favors the 2% inflation target as ordinary people struggle to make ends meet. Trudeau said families, not monetary policy, would be his administration’s top economic priority and wants to continue with more stimulus.

New data released Wednesday showed that annual consumer price increases accelerated to 4.1% in August, the fastest inflation rate since 2003 and the fifth consecutive reading above the Bank of Canada’s 3% cap. That landscape of accelerating inflation will, of course, be critical of monetary policy: The BOC boss said earlier this month that he plans to scale back bond purchases as the economy recovers, leaving the opportunity for higher rates open as consumer costs rise. continue to rise. But it may also have an effect on the election results themselves, the type of fiscal policy that results, and the final decision on the BOC mandate.

“Election results can have an impact on fiscal policy, which reverberates in monetary policy or vice versa,” said Tom Nakamura, portfolio manager at AGF Management. “There is some concern about the election.”

Above all this looms the specter of the US monetary policy decision next Wednesday. Any notable signals from the Federal Reserve about its potential timeline for phasing out asset purchases or raising interest rates are likely to have a significant impact on risky assets around the world, including the Canadian dollar and the commodity complex.

“Obviously the Fed is going to start the winding down process this year and at the same time we hit the peak of the BOC hawkish,” McCormick said. “Loonies’ biggest driver now is the dollar outlook and global risk sentiment.”

(Updates with loonie performance in the third paragraph and prices throughout.)

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