January 21, 2011 / 2:25 PM / 7 years ago

Canadian dollar set to outperform commodity rivals

LONDON (Reuters) - A shift by investors in commodity currencies should see the Canadian dollar outperform its close rivals, buoyed by a hawkish interest rate outlook, high oil prices and an improving picture for the U.S. economy.

The Bank of Canada may have sounded a less hawkish tone than some had been anticipating when it kept interest rates on hold on Tuesday, but most Canadian primary dealers still see a rate hike coming in the first half of the year, according to a Reuters poll.

Analysts expect the rate outlook to keep the currency on a firm footing against the Australian and New Zealand dollars. All three are growth-linked currencies and are generally sought after when investors grow bullish about the global economy.

“Market pricing for Canada rate hikes is still more aggressive than for Australia or New Zealand,” said UBS currency strategist Gareth Berry “For this reason we expect to find profitable opportunities this year in rotating out of the Aussie and New Zealand dollar longs and into the Canadian dollar.”

With commodities prices at two-year highs, according to the Reuters Commodity Index and Australian interest rates at nearly 5 percent, investors flocked to the Australian dollar in 2010, but the impact of rate hikes and severe flooding has dented consumer confidence and the Aussie rally has stalled.

Financial markets, based on interest rate swaps and the futures market, are pricing in the chance of only one quarter percentage point interest rate hike by the Reserve Bank of Australia in the next twelve months.

Investors are fully pricing in two New Zealand rate hikes, and a 40 percent chance of a third this year. but there is a chance this could be pared back as New Zealand stares at a return toward recession after unexpectedly slow economic growth in the third quarter of 2010. Analysts say benign inflation could delay rate rises.

Canadian overnight indexed swaps, which trade based on expectations for the key central bank rate, show the implied rate at 1.57 percent, implying two full hikes and a 30 percent chance of a third by December.

BRIGHTER OUTLOOK

A combination of higher commodity prices, expectations of tighter monetary policy by the Bank of Canada and a brighter economic outlook has driven the Canadian dollar to a 2-1/2 year high on the U.S. dollar.

That has prompted the BoC to express some discomfort with its strength.

UBS’s Berry said that while a correction against the U.S. dollar was likely, it did not affect his view that the Canadian dollar would outperform on the crosses. He added the U.S. economy’s impact on Canada was similar to that of China’s on Australia.

Canada’s sensitivity to the U.S. economy, by far its biggest trading partner, will be of benefit so long as the United States continues to recover.

“The Canadian dollar was held back last year by the performance of its major trading partner,” said David Watt, senior currency strategist at RBC Dominion Securities in Toronto.

“But this year it’s the opposite, and the Australian dollar is likely to be held back by China’s tightening measures. We favor outperformance in the Canadian dollar generally.”

Watt cited a shift in the direction of the spread between the two-year Australian and Canadian interest rate swap spread., which staged a sharp bounce between May and October 2010. It is back around 3.4 percent after topping out around 3.8 percent in October.

A sharp rebound in crude oil prices is another factor lending support to the Canadian currency. Crude has bounced around 30 percent from a low plumbed in May 2010.

“The oil market has lagged base metals, but with oil starting to tighten up and if U.S. economy continues to improve, oil should continue to benefit and that lends strong support to the Canadian dollar,” said RBC’s Watt,

His initial target for the Aussie/Canadian dollar pair was the 200-day moving average around C$0.9535. It currently trades around 0.9860 after hitting a 6-1/2 year high above 1.02 in December.

“As the oil price climbs we are expecting it to lend material support to the Canadian dollar,” said Phil Roberts, technical analyst at Barclays. “The CAD is being supported now not just by rising commodity prices, but also by aggressive policy tightening expectations.”

The latest positioning data has shown a switching out of Australian dollars into the Canadian dollar, lending further support to CAD bulls.

Risk-reversals, a measure of the premium required to hold a call or a put in a currency pair, have increasingly shown investors hedging against a rise in the Canadian dollar in recent months.

The one-month 25-delta trades around 1.00 for Aussie puts versus around 0.30 in September. The one-year stands around 1.50 for Aussie puts versus 0.90 in September, according to UBS data.

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