FxWirePro: Cognizance of driving forces and hedging frameworks of CAD/JPY

BoC is scheduled for monetary policy announcement (today). The Canadian economy has been able to grow considerably over the past quarters predominantly driven by an expansionary monetary and fiscal policy. It is projected that the growth rates of around 3% for 2017. Owing to the boom observed, the Bank of Canada (BoC) began to raise interest rates last year in order to counteract possible inflation risks. The consensus is that the Canadian central bank is expected to raise 25 bps in its overnight rates.

For the FX market, the reversal of the previously very cautious BoC came as a surprise in the summer, which is why the CAD appreciated by more than 10% against the USD within three months.

As a result, the BoC has become more cautious and has taken a pause in interest rates. After all, it does not want to burden the economic outlook too much with a strong CAD, which is why the CAD exchange rate should have a considerable influence on the pace of BoC interest rate hikes this year.

In loony’s fair assessment, the monetary policy to be more decisive than oil prices. The oil performance has been instrumental in boosting the currency in 2017, even though the long-term picture suggests that the currency has overshot the rebound in oil prices. However, the CAD is on the right track to remain strong: the interest rates factor is taking over from the commodity factor. CAD rates recently climbed above USD rates for the first time since 2014 (refer above graph), and our USD rates projections can realistically drag the USDCAD to 1.20.

The Bank of Canada (BoC) has become more cautious again, after CAD appreciated heavily following two rate hikes. In view of numerous risks (inflation, oil price, NAFTA) the BoC does not want to be overly optimistic.

We assume though 25 bps hikes are expected today, but for the time being the BoC would initially follow the Fed’s rate hike speed so as to prevent strong CAD appreciation against USD. The better growth outlook in Canada as well as the more stable political environment will however allow gradual CAD appreciation in the future.

Notably, please be informed that the CAD implied vols are on lower side among G7 FX space, given the low-yielding / funding currency status of both USD and JPY, and CAD’s traditionally tight link to the global growth cycle that tends to exert similar directional influence on both pairs, above-average correlation is the norm rather than the exception for CADUSD and CADJPY; the above chart shows that a hypothetical strategy of systematically owning CADUSD vs CADJPY correlation swaps would have generated high Sharpe Ratio returns (excluding transaction costs, hence hypothetical) over a long history spanning multiple volatility cycles.

A transaction-cost friendly version of the full correlation triangle is to buy CADJPY – USDJPY vol spreads that are historically low (6M ATM spread 0.9 vs. 3-yr avg. 1.6), offers marginal (0.5 vol pts.)

Thus, we wish to offload the put side of options strips strategy that was advocated a fortnight ago and prefer 3m USDCAD +0.51 delta ATM call. While CADJPY seems to be like a straddle containing ATM puts as well as calls of 2m tenors.

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