Canada's Loonie Takes Flight

By David George-Cosh Features Dow Jones Newswires

The Canadian dollar is on a tear, and traders and investors are betting it will remain strong.

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The currency, known as the loonie for the bird on its single-dollar coin, is up about 10% against the U.S. dollar since early May, boosted by a string of strong economic indicators and the Bank of Canada's first policy rate increase in seven years.

On July 18, investors took a net long position in the Canadian dollar--a bet that the currency would appreciate--for the first time since March. On Friday, data from the U.S. Commodity Futures Trading Commission showed investors held about 26,000 more long than short contracts on the Canadian dollar in the week ended July 25, up from about 8,000 long contracts in the prior week.

"There's a lot of things conspiring to keep the Canadian dollar firm around these levels," said Bipan Rai, senior macro strategist at CIBC Capital Markets. "It looks like the loonie's strength is here to stay."

The quick rise of the Canadian dollar reflects recent signals that Canada's economy has now turned a corner after the commodities slump. Traders and currency analysts say it is unlikely to climb significantly higher, and its strength could even damp the country's resurgent growth, posing a challenge for policy makers.

Currently trading around the 80 U.S. cent mark, the Canadian dollar had not long ago been hurt by an oil-price slump, becoming one of the worst-performing currencies over the past three years. It sunk to as low as 68 U.S. cents in January 2016 after hitting parity with the greenback in early 2013.

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That weakness began to unwind throughout the past year as the currency, weighed down by investors taking bearish bets, helped the Canadian economy sputter back to life.

The loonie is also playing catch-up after its steep decline in April, when the U.S. slapped onerous tariffs on Canadian lumber, spooking investors who rushed to reduce their exposure to the export-sensitive Canadian economy. The tariffs, and related fears about hard-line changes to the North American Free Trade Agreement, pushed the currency to a 14-month low.

The Canadian dollar began to strengthen in May amid reports showing exports jumped nearly 18% to 48.69 billion Canadian dollars (US$38.78 billion), the strongest 12-month showing in nearly six years. Meanwhile, economic indicators measuring employment, retail sales and business-investment intentions gave the Bank of Canada confidence the time was right for a rate rise.

Earlier this month, the Bank of Canada moved to raise its policy rate a quarter of a percentage point to 0.75%, and overnight index swaps show investors believe the central bank will increase again by the end of the year. That caused the loonie to post its biggest rally in about a year, as the U.S. dollar closed at C$1.2751, down from C$1.2916 from the previous day.

Since then, the Canadian dollar has crept even higher, boosted by a softer greenback and more good economic news out of Canada. The currency rallied on Friday after stronger-than-expected May gross domestic product figures, closing near 80.40 U.S. cents from an open on 79.57 U.S. cents.

The International Monetary Fund on Monday improved its outlook on the Canadian economy to 2.5% this year, a growth rate that leads the Group of Seven economies, up from the 1.9% it originally forecast in April. The Bank of Canada forecasts 3% growth in the second quarter while the economy should moderate in the second half of the year.

"Everything is looking quite rosy for the Canadian economy," said Dave Bradley, director of foreign exchange trading at Scotiabank global banking and markets. "Still, it looks like the Canadian dollar may have gone a little bit too far, too quickly."

Its fast appreciation may not be welcomed by the Bank of Canada considering the resulting drag on the economy, said Krishen Rangasamy, senior economist at National Bank Financial. That 10% gain is equivalent to a half-percentage point interest rate increase while trimming about 0.3% in real gross domestic product from the Canadian economy. It is also unlikely to change the central bank's recent hawkish tone to markets if it manages to keep Canada's housing sector stable, Mr. Rangasamy said.

Mr. Bradley sees some opportunity for the loonie to gain a few more pennies against the U.S. dollar in the coming days, but it should consolidate around current levels given the Bank of Canada's next rate move is likely priced in. Any sudden moves would likely come from a major event, such as any fallout from negotiations over Nafta or a potential rate move from the Federal Reserve later this year.

And while the Canadian dollar's moves have recently decoupled from oil prices, it remains sensitive to U.S. dollar moves over the next several quarters. The U.S. dollar has become a sort of proxy for the Trump administration, noted several economists.

"There's a reason to sell the U.S. dollar after every misstep by the administration," said Frank Maeba, managing partner at Breton Hill Capital Ltd., a Toronto-based hedge fund with $1.7 billion in assets under management.

He has previously shorted the Canadian dollar but has reversed that position after seeing Canada's economy strengthen in the past several months.

"You don't typically see the Canadian dollar move like this," Mr. Maeba said. "It's likely to quiet down for a while."

Write to David George-Cosh at david.george-cosh@wsj.com

(END) Dow Jones Newswires

July 29, 2017 07:14 ET (11:14 GMT)