FOREX

USD/CAD Breaks Out in Crowded Trade, Uptrend May Continue After Pullback

Witawat (Ed) Wijaranakula, Ph.D.
Thu Dec 24, 2015

The Canadian dollar has taken a beating since July 2014, when crude oil prices broke down below the $92.50 a barrel level, as the commodity-based currency is heavily dependent on commodity prices, largely crude oil. The loonie was under pressure during the first half of 2015, as the Canadian economy slipped into recession, while the gross domestic product (GDP) contracted at a 0.6% and 0.5% annualized rate in the first- and second-quarters, respectively. 

The USD/CAD broke out the 4-year trendline resistance to close above the 1.37 level on Friday, December 11, as investors raised concerns about crude oil prices falling to a level not seen since February 2009, and a rout in the junk bond market. Carl Icahn, activist investor and fund manager of $30 billion Icahn Capital Management, told CNBC that, "The high-yield market is just a keg of dynamite that sooner or later will blow up,". 

Icahn’s comment came after Third Avenue Management and Stone Lion Capital Partners suspended redemptions to avoid investors from withdrawing money from their $1 billion junk bond funds that they are trying to liquidate. Soon after, Lucidus Capital Partners, a high-yield credit fund, liquidated its entire portfolio and returned the $900 million it had under management to investors, according to Bloomberg.

The weakness in the Canadian dollar has driven Canadian companies, such as Calgary-based Bellatrix Exploration Ltd., to the U.S. to sell high-yield unsecured notes with yield premiums several percentage points higher relative to U.S. peers, according to the Globe and Mail.

Tumbling crude oil and commodity prices put more of a squeeze on U.S. and Canadian energy and mining companies that issue high-yield, or junk bonds, to finance their operations. There could be as much as $378 billion worth of junk bonds in energy and basic industries sectors out there, according to Bank of America Merrill Lynch. Standard & Poor's Ratings Service recently warned that 50% of energy junk bonds are "distressed," meaning they are at risk of default.

As of December 15, there were 55,149 short positions of Canadian dollars, traded on the Chicago Mercantile Exchange (CME) in units of 100,000 Canadian dollars, by leveraged funds, an increase of 9,604 contracts from the previous week, according to the Commitment of Traders (COT) data released by the Commodity Futures Trading Commission (CFTC) each Friday. This is compared to about 21,976 long positions, a decrease of 3,949 contracts during the same period. 

The net short positions increased by 2,748 contracts, worth about 1.36 billion CAD, reflecting the likelihood of continuous weakness in commodity prices and the Canadian dollar. U.S. dollar bulls are betting big on the Federal Reserve’s so-called dot plot, as the Fed expects the fed funds rate to rise to 1.375% by the end of 2016, meaning at least four more quarter-point rate hikes next year.

At the press conference after the U.S. Federal Open Market Committee (FOMC) meeting last Wednesday, Fed Chair Janet Yellen made it clear that the pace of increases will be gradual and dependent on the quality of economic data. Although the Fed’s objectives are maximum employment and a 2% inflation target based upon core personal consumption expenditures (PCE), the Fed expects core PCE inflation to reach 1.6% in 2016 and 1.9% in 2017.

The U.S. economic readings this week have been a mixed bag. The U.S. Department of Commerce said on Wednesday that new orders for manufactured durable goods, products designed to last at least three years, increased $0.1 billion in November, or virtually unchanged, to $238.8 billion. Orders for durable goods in the first 11 months of 2015 fell 3.7% from the same period a year earlier. A closely watched proxy for how much businesses are spending on new equipment — the non-defense new orders of capital goods excluding aircraft, decreased $5.2 billion, or 6.3%, to $77.2 billion in November. 

“Unless we see a big rebound in December or upward revisions, it appears that investment in equipment contracted in the fourth-quarter,” said Paul Ashworth, chief U.S. economist at Capital Economics, according to The Wall Street Journal. Forecasting firm Macroeconomic Advisers said Wednesday it expected U.S. GDP to expand at a 1.7% pace in the fourth-quarter, cutting its earlier projection of 1.9% growth.

Separately, the Department of Commerce said the latest reading of the core PCE for November came in at 109.96, or 1.33% year-on-year, little changed from the previous month’s 1.28%. Thus, the Fed may have to sit and wait for a while until inflation gets to their target level, especially when the crude oil price is tumbling. Yellen thinks that crude oil and other commodity prices will find the bottom sometime and inflation will start rising. That is what she hopes.

From our technical viewpoint, the USD/CAD has been moving in an ascending broadening (ASC/B) wedge chart pattern since July 2012, with an accelerated uptrend move in July 2014. The currency pair broke out the 4-year trendline resistance, but was unable to move across the 1.4 level, due to either being overbought or to the mixed bag of U.S. economic news of late. The USD/CAD could pull back temporary, but most likely will move gradually higher, as commodity prices are expected to remain weak throughout 2016.

According to John Baffes, Senior Economist at the World, the five-year-long slide in most commodity prices is expected to continue, as there are sufficient inventories of oil and other commodities and demand is weak, especially for industrial commodities, which is why prices may stay persistently low.

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