On July 20, the Bank of Canada raised its key short-term interest rate for the second month in a row by 25 basis points, to 0.75 percent. Hawkish policy should support gains in the Canadian dollar, and it’s worth considering bullish strategies using futures and options. However, parity with the U.S. dollar could prove strong resistance in the near-term.
The BOC rate hike was certainly not a surprise—20 out of 20 analysts surveyed by Bloomberg expected this result. What market participants were dissecting was the wording in the statement from policymakers. The BOC said: “the global economic recovery is proceeding but not yet self-sustaining. Greater emphasis on balance sheet repair by households, banks and governments in a number of advanced economies is expected to temper the pace of global growth.”
The BOC lowered its growth expectations for Canada in 2010 – 2011, with GDP expected at 3.5 percent this year and at 2.9 percent next year. However, most analysts expect more increases ahead, despite the somewhat dovish tone. The BOC said its current policy leaves “considerable monetary policy stimulus in place,” and that “any further reduction in monetary stimulus would have to be weighed carefully against domestic and global economic developments.” That leaves the door open to more rate hikes, but the pace could be slow, with some pauses.
Immediately after the policy announcement, the Canadian dollar fell, but then came back up sharply. September CAD futures broke above the 18-day moving average, a bullish technical development. If this pace of gains were to continue, the CAD would move well above par in days. However, I don’t think that will play out. There is good resistance at 0.9650 and 0.9700 in the futures, and the market may see some periods of consolidation following gains. I see support around 0.9450 and 0.9375 during these periods.
The Relative Strength Index (RSI), a momentum indicator which helps determine whether a market is overbought or oversold, is at 47 for the Canadian dollar futures. Typically, as RSI approaches 30, the market is considered oversold, and as it approaches 70, it’s considered overbought. So the market is right within that range right now. I’d typically like to see the RSI move closer to 40 or below to recommend buying, but I still feel there is upside potential at current levels. The market is not near key resistance yet.
Even with the rate hike, Canada’s short-term lending rate is still very low on an historic basis, lower than it has been during other recessionary periods (see graph below). I would expect further raises to bring the rate closer to 2 percent, with the next one most likely in September. We could see a few increases in a row, then a pause. The BOC’s rather soft wording at the July meeting could be hinting at this type of approach.
Inflation and Employment
Keeping inflation low, stable and predictable is the primary goal for the BOC, and its target range is from one to three percent. Inflation is running at 1.4 percent (based on the consumer price index), so there is still room for prices to increase before we have a real concern.
The unemployment rate for Canada is another factor to consider. It moved up rapidly during the recession, but has fallen back to 7.9 in June. There is still room for improvement, but labor force growth is moving back toward 2008’s levels, and it is based on a broad pool. Job growth is rolling along; 403,000 new jobs have been created since July of last year. The economy is picking up, and this should bode well for the Canadian dollar.
Canada Dollar Trade Strategy
The Canada dollar hit parity in April, then started to pull back. Right now I think support should hold at 0.9350 – 0.940, and the upper range should hold at 0.9850 for at least this quarter. For the third quarter, analysts expect the Canadian dollar futures to trade around 0.97 ($1.03 in Forex terms), then up to 0.99 in the fourth quarter. I think these seem like reasonable estimates.
To take advantage of these expectations, there are a few strategies to consider. You can simply buy Canadian dollar futures at current levels. However, I think the market may have moved a bit too fast after the rate announcement, and would recommend waiting for a pullback to 0.97 – 0.95. You could also considering sell puts on the Canadian dollar. You collect a premium when you sell a put, and may or may not be assigned a position in the futures depending on where the market is at expiration. Here’s how this would work based on prices on July 20, 2010
Current price 0.9575
Strike 0.9400
Premium 0.01 or $1,000
45 days to expiration
Breakeven at 0.9300
In 45 days, if the underlying price of the futures contract is below 0.94, then I will be required to purchase a Canadian dollar futures contract at a price of 0.94. If the price is above 0.94, I simply collect my premium and walk away.
As long as the market is above 0.93, your trade will be profitable (not considering your commissions). This is a good way to get into the market without having to buy at current levels (0.9575) and withstand what could be considerable volatility. The market has been erratic, so this type of option strategy will allow you to participate in the market without having to buy right now. And, you have the opportunity to collect some premium to offset the costs involved if you are assigned a futures position—or keep it as profit if you are not.
Drew Shaw is a Senior Market Strategist based in Lind-Waldock’s Toronto office, and is serving clients in Canada. If you would like to learn more about futures trading you can contact him at 877-840-5333, or via email at dshaw@lind-waldock.com.
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