It's one thing to fade broad Goldman trade recommendations (and thus trading alongside Goldman and against muppets). It is, however, a gift from god when such a trade comes from none other than the greatest (once again, if you bat 0.000 or 1.000 on Wall Street you are great in both cases) FX strategist of all time: Goldman's Tom Stolper, whose fades over the past 5 years have generated over 20,000 outright pips. So what does Stolper see? "All told, there are a number of reasons why the Canadian Dollar has scope to weaken. Some of these have been a factor for some time but the notable weakening in the external balance, the gradual shift in the BoC communication and the prospect of Fed tapering and the associated risks all suggest that 2014 may be the year when the CAD weakens more materially after many years in narrow trading ranges. In line with our recently changed forecasts, we expect $/CAD to rally to 1.14 on a 12-month basis, with a stop on a close below 1.01. This would imply a potential return of 7% including carry." So one Goldman 2014 Top Trade generates a total return of 7% in 12 months - and one should do this why when one can make 7% in the Russell 2000 at its current daily pace of increase of 1.0% in one week. That said, the only question is: 1.01 in how many days?
Top Trade Recommendation #3: Long $/CAD on external deficits, tapering risks
A weak external position suggestive of a weakening CAD
Since the Global Financial Crisis, significant external imbalances have built up in the Canadian economy. In 2008, the current account balance fell from a surplus of 1% of GDP to a deficit of 3% - and it has remained stable at this level since then. The main reason for this has been a decline in manufacturing exports, which fell by about 30% during the crisis. Employment in the manufacturing sector declined by about 20% during the crisis and has not recovered. On the commodity export side, the rise in crude production linked to tar sands in Alberta roughly offset the decline in the value of natural gas exports. The overall trade balance in energy-related products has remained unchanged during this period.
The decline in the Canadian current account position into deficit was initially funded easily. A strong banking sector that weathered well the GFC made Canada a safe haven currency with strong portfolio inflows. Early rate hikes in 2010 created a small interest rate differential in favour of the CAD and a particularly strong reserve diversification flow into Canada also contributed to solid capital inflows. From 2008 to 2012 the Canadian BBoP (= current account + portfolio flows + net FDI) remained very strong, recording a surplus of about 2% of GDP. But this has changed in 2013.
Over the past few quarters, capital inflows have slowed rapidly, pushing the BBoP into deficit of about 1% of GDP currently. Slowing reserve diversification has almost certainly contributed to this. According to the latest COFER data, EM central bank holdings of CAD have remained broadly stable in the first half of 2013 – a trend that has likely continued since. Without continued additional reserve diversification inflows, the CAD has likely lost one of the primary funding sources for the sticky external deficit.
Low inflation and weak exports to keep policy rates low
As Robin Brooks and Mike Cahill discussed in the latest Week Ahead piece for Canada, the weakness in exports has increasingly become a concern of the Bank of Canada (BoC), together with persistent low inflation. Markets have already revised substantially their expectations for monetary policy. Cumulative rate hikes priced through the end of 2014 have declined from about 50bp in September to around 5bp currently. Our forecast is for the BoC to stay firmly on hold until the Fed starts raising rates in 2016. That said, with house prices already very elevated, as documented by Hui Shan in a recent Global Economics Weekly, it is likely that private consumption will no longer be the kind of positive impulse to the economy that it was in the past, and we expect Canada’s growth in 2014 (2.1% on our forecast) to lag behind that of the US (2.9%) for that reason. In addition, as we have been flagging, CPI inflation has been stuck at the lower end of the BoC’s 1-3% inflation target band. This could become a more material issue for the BoC should inflation not move back towards the middle of the band in coming months. Again, our baseline is for the BoC to be on hold, but since the money market curve is pricing a small chance of hikes through end-2014, we see risks here also skewed to the downside. Again, this is supportive of CAD weakness.
It is also important to highlight that the Canadian Dollar remains clearly overvalued on our GSDEER fair value model. Combined with the weak current account position, there are therefore good fundamental reasons for a weaker CAD. Should a more accommodative policy by the BoC lead to a weaker CAD, it is unlikely that policymakers in other countries would complain about an explicit attempt by the Canadian authorities to gain an unfair competitive advantage.
Combining all these factors, we see good reasons for gradual CAD weakness to persist for idiosyncratic reasons. The kind of price action consistent with external weakness is a steady drift weaker and gradual underperformance relative to other major currencies, in particular the USD.
A possible sharp acceleration on Fed tapering
The reason why the down move in the CAD could accelerate notably would be the expectation for tighter monetary policy in the US. In particular a sell-off in intermediate rates in the US could lead to a widening interest rate differential at the 5-year point in the curve of the US.
Purely from an interest rate differential angle, this would likely add a factor in favour of a rising $/CAD. There is an additional risk that the sell-off extends into the front end of the US curve in response to stronger growth, as we discussed in some detail in the outlook for 2014. The risk of this scenario materialising is also linked to the asymmetric risks to interest rates, coming from very low levels. Running our Correlation Cruncher, we find that in recent months $/CAD has been almost twice as sensitive to a move in US 2-year rates as to the Canadian 2-year rate. Therefore, and if these correlations persist, even a simultaneous sell-off in Canadian front-end rates would remain a net negative event for the CAD.
Finally, it is worth putting the risk of higher US rates into the context of the external funding needs. It will likely become more difficult for Canada to attract the necessary inflows to fund the current account deficit if bond yields rise in the US.
External deficits, reserve flows, growth and tapering
All told, there are a number of reasons why the Canadian Dollar has scope to weaken. Some of these have been a factor for some time but the notable weakening in the external balance, the gradual shift in the BoC communication and the prospect of Fed tapering and the associated risks all suggest that 2014 may be the year when the CAD weakens more materially after many years in narrow trading ranges.
In line with our recently changed forecasts, we expect $/CAD to rally to 1.14 on a 12-month basis, with a stop on a close below 1.01. This would imply a potential return of 7% including carry.