The Bank of Canada's recent change in tone has led to a strong appreciation of the Canadian dollar against other major currencies since the beginning of June. This sharp appreciation was also amplified by a radical shift in the sentiment of speculators towards the loonie, since they had to close their historically high number of short positions held on the Canadian dollar while the currency rallied. Indeed, in early May, we pointed out that the sentiment of speculators against the loonie had turned too negative, while the number of short positions in the Canadian dollar held by non-commercial traders had increased by more than 77,000 contracts in the previous eight weeks; a change that last occurred back in April 2013. We then argued that this negative positioning was highly vulnerable to a potential rebound in energy prices or a more positive tone than expected from the Bank of Canada on the economic outlook and that a possible improvement in the sentiment of speculators could then lead to a reversal in the loonie; this scenario has finally materialized.
On the other hand, the shift in sentiment from non-commercial traders towards the Canadian dollar in recent weeks has now reached historical levels. According to the Commodity Futures Trading Commission’s weekly Commitments of Traders report published on July 21st, in percentage of open interest, the Canadian dollar speculative net position has now jumped by more than 32% over the previous eight weeks. As illustrated below, this positive change has now hit the upper-end of its historical range, which in the past has generally marked an imminent change in the currency trend. Indeed, it is interesting to note that since 2010, the value of the loonie against the U.S. dollar tended to depreciate (USDCAD rising) when the change in tone of speculators reached such historical levels.
The sentiment of non-commercial traders has evolved so dramatically in the space of only two months that we must now question whether market participants have not suddenly become too optimistic about the loonie.
For example, a potential deterioration in the economic outlook could again lead to a widening in U.S.–Canada yield spreads and, consequently, a depreciation of the Canadian dollar. After all, the recent increase in interest rates, the appreciation of the Canadian currency or even a decline in global economic momentum could restrain the economic and inflation outlook in Canada. With so many positive economic developments already priced in by market participants, the loonie is largely vulnerable to disappointments.
In addition, as illustrated below, the spread between U.S. and Canadian economic surprise indices has now reached the bottom-end of its historical range and, if history is any guide, a coming underperformance in Canadian economic data could well be around the corner. This could lead to a rebound in U.S.–Canada yield spreads. In our view, the sentiment on the Canadian dollar has appreciated too rapidly in recent weeks and there is an opportunity for investors to sell the Canadian dollar from a tactical point of view.
