Is It Time to Short the Loonie?

02/18/2013 9:00 am EST

Focus: CURRENCIES

Canada emerged from the global  financial crisis relatively unscathed, but recent weak economic data will increasingly put pressure on the Canadian dollar, which is why Andrea Cohen offers this trade on DailyForex.com.

Recent events as well as economic data published lately all indicate that the Canadian dollar will be facing headwinds in the near future. We suggest exploring the idea of selling the Canadian dollar, especially against the US dollar and currencies highly-correlated to the US dollar (Mexican peso, for example).

The most alarming warning signs in our view come from the housing sector. For a good few years now, real estate (residential especially) prices have risen persistently. It got to a point that policy makers actually recognized that there was a bubble (not that they ever used the B-word) and took measures to smooth exiting this condition. New rules governing eligibility and equity investment for mortgage seekers have helped cool the market to a certain degree: December 2012 is a good example of the situation we are in: sales were down more than 17% relative to December 2011 (across the country, not just concentrated in one inflicted area), but prices a bit higher. To us, this is a sign of a bubble waiting to burst as demand-drying prices are bound to plummet soon.

In late January, rating agency Moody’s downgraded six major Canadian banks. Moody’s quoted personal debt and unreasonably elevated housing prices as main reasons for that downgrade. 25% of the bank’s assets are in residential mortgages and therefore essentially indexed to housing prices. The Moody’s write up about the downgrade makes for an alarming reading as it also touches the Canadian economy as a whole, not just the banks.

Another issue that should be of concern to Canada is the increasing attractiveness of Shale Gas for the US. This could be a trigger for a drop in oil prices, which makes for such a large portion of government income in Canada. For instance, Alberta, a province, which has zero debt is now contemplating a new sales tax (no sales tax there at the moment) to make up for a huge shortfall from oil income.

Lastly, and this, too, is reflected in Moody’s report, is the reliance on the emergence of the US from the economic downturn. The housing sector in the US is the primary market for Canadian lumber for instance. In general, being Canada’s main trade partner (by far) makes Canada very sensitive to the situation in the US. Not that we strongly believe that the recovery in the US is facing headwinds, but this is an external factor that Canadian policy makers have no control over and therefore should add to risk.

There are two main ways to make this bet: either long USD/CAD or long MXN/CAD.

Long USD/CAD is the more straight-forward manner to bet against the CAD. The advantages here are liquidity and speed to reaction to news and data.

Long MXN/CAD is less liquid and typically a slower mover than the USD/CAD, but has a potential to gain on both ends: not only from a weaker Canadian dollar, but also from a relatively stronger Mexican peso. As another economy for which the US is the main trading partner, trading the MXN/CAD in a sense mitigates exposure to the US. Another way of looking at this is that the MXN is sensitive to other parts of the US economy than the Canadian dollar and with the risk of scaling back in recovery, this is less unfavorable to Mexico than to Canada.

By Andrea Cohen, Contributor, DailyForex.com

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