Canada’s economic soundness has been the envy of many other nations around the world, and its strong banking system has received a lot of attention. Canada came out of the recession of 2008 – 2009 better than many of its G7 partners. Canada boasts an exceptionally strong financial system, ranked as best in the world by the World Economic Forum. Canada has become a model for other nations.
Solid employment and housing trends in Canada show stark contrast to the dreary statistics out of the U.S. In June, 93,000 jobs were created in Canada, and the unemployment rate fell to 7.9 percent. Nearly all of the jobs lost during the recession have been recovered over the past year. Most of the gains in June were based in the service sector, with strong job creation in retail, building, health care and other support services. One weak spot was manufacturing, which dipped 14,000 in June. This year as a whole, construction has been particularly strong, up 8.3 percent.
Rate Increase Seems Likely
Given the strong economic statistics, it seems likely the Bank of Canada will increase its key short-term interest rate to 0.75 percent at the July 20 policy meeting. It would be the second rate increase this year, and would likely to cause the Canadian dollar to appreciate. Business owners and leaders are feeling more comfortable overall expecting positive business conditions over the next 12 months, despite global economic uncertainties. The Bank of Canada will also release its monetary policy report on July 22, and this is something traders and investors will want to take a close look at.
The Canadian financial sector is strong relative to the rest of the world, and has been relatively unaffected by the funding constraints in other markets. The Canadian banking industry remains profitable, and we’ll get a view of this in August when earnings are released. Capital ratios continue to rise and asset quality has improved since last year.
There are some potential vulnerabilities, however. The weakness in the U.S. real estate sector remains a pocket of possible fragility, as well as European sovereign debt issues. If these problems result in deterioration in international financial conditions, the quality of Canadian bank assets will be impaired, even without a large direct exposure.
Canada’s current deficit stands at approximately $47 billion in the last fiscal year, which is lower than the $54 billion projected in the budget. The government is in the process of closing its stimulus program, which should bring the deficit down further to $27 billion by year end. Canada is leading the way in getting its budget into balance before 2013. Canada’s debt-to-GDP ratio is about 53 – 54 percent, better than most countries. For example, the U.S. debt-to-GDP ratio is at 94 percent, and Japan and Italy are over 100 percent.
Currency Risks
While there is much good news in Canada, there are some risks. The Canadian currency has been highly correlated with the “risk trade.” The risk trade is when investors take their money out of safe havens such as the U.S. dollar or bonds, and move into what’s perceived as more risky assets with potentially better returns, such as commodities. The Canadian economy relies on commodity exports, so trends in commodities also affect the currency, regardless of the country’s fiscal standing. Lower commodity prices could lead to weakness in the Canadian economy. And, if the Canadian dollar gets too strong, it could squeeze profit margins for global export companies.
Managing Currency Risk
I believe any company with international exposure should manage their currency risk, and futures contracts are a great way to do so. They are particularly well-suited to small businesses. They have lower transaction fees than OTC foreign exchange, and relatively low margins offer what is essentially a cheap insurance policy. Each contract has a $100,000 notional value, and for about $2,400 in margin (subject to change), you can hedge $100,000 of currency.
Here is a simple example. A business expects to receive $200,000 USD in six months, and is concerned about likely CAD appreciation affecting the conversion. It does not have the cash to convert now. So here’s the strategy:
By two December CAD futures contracts at 0.95
The currency appreciates to 0.99
Profit on Futures = .04 x 2 x $100,000 = $8,000
Comparing the opportunity cost on the currency transaction if the risk is not hedged.
Convert the cash if we had it today $200,000 x 1.05 = $210,000
Convert when cash received in six months $200,000 x 1.01 = $202, 000 = ($8,000)
So, the profit on your futures contracts offset that loss of not converting today.
There are lots of strategies for speculators as well. The bias to me looks stronger on the upside from both a technical and fundamental standpoint and favors bullish positions. The U.S. earnings season is currently fueling a equity market rally and supporting the currency. Next week, we’ll see if we get an interest rate increase from the BOC, which would likely cause further gains in the Canadian dollar, possibly making another run at par.
Technically, the market also looks bullish. A chart of the Canadian dollar shows it is trading above its 50- and 200-day moving averages. Resistance looks to be around 0.98 in the September futures contract.
Conservative investors might want to wait for a pullback to 0.94 – 0.95 and buy futures at those levels. If we get an interest rate increase from the BOC and good corporate earnings reports, the CAD should move up.
Speculative investors could also consider selling Canadian dollar puts around 0.94-0.95, and collect the premium. If the market moves up to par, you keep the premium and there’s no loss on the trade. If the market moves below your strike price (0.95), you will be assigned a futures contract. But if you don’t mind owning the CAD at that level anyway, it could be a good strategy to consider.
Kyle McEwan is a 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 kmcewan@lind-waldock.com.
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