FxWirePro: Canadian economic slack warrants BoC’s status quo – “Diagonal Debit Put Spread” to keep EUR/CAD’s downside risks on check

The statement from BoC’s March 1st meeting reiterated the point that, unlike the US, Canada was an economy that continues to be beset by material excess economic slack, and thus warrants a policy stance that remains very dovish. 

This reinforce an argument made by Governor Poloz in his January policy meeting press conference that because of this cyclical divergence, it is unjustified for rising US rates and USD to drag up higher Canadian rates and CAD (in trade-weighted terms), and that recent tightening in monetary conditions from both rates and the currency was unconstructive for Canada. 

This point of view played out this past month, as the sharp move 23bp higher in US 2y yields largely did not spill over into Canada yields.

OTC updates and hedging vehicles:

At spot ref: 1.4363 (while articulating) we advocate below FX derivatives strategy as we favor optionality to the directional trades. For the bearish streaks that we are inclined to position a partial retracement of the down move through put spreads, as calling the bottom is difficult and adding directional spot exposure is risky at the moment.

Alternatively, using any abrupt rallies, you decide to initiate a diagonal debit/bear put spread (DDPS) at net debit 2w ATM IVs of EURCAD is at 7.31%, and likely to spike higher 8.55% in 2m tenor. While positively skewed IVs of these tenors indicate hedgers’ interest in OTM put strikes that implies downside risks in the underlying spot FX.

The execution: Initiate shorts in 2W (1.5%) out the money put with positive theta, simultaneously, buy 2M in the money -0.5 delta put option. Establish this option strategy if you expect that EURCAD would either expect sideways or spike up abruptly over the next near future but certainly not beyond your upper strikes.