FxWirePro: Canadian Dollar Vulnerable On Pandemic Crisis, CAD/JPY Options Strips Best Positioned As More Downside Likely On NEER Terms

CAD weakened sharply, including by more than 9% in mid-March, as the global pandemic has aggressively spread westward. On net, the currency is 5% weaker from pre-crisis levels. CAD has also managed to modestly outperform its higher-vol commodity currency peers, but various benchmarks suggest room for more CAD weakness. Despite the second-largest monthly range for USDCAD since 2008, CAD’s net depreciation has been relatively orderly, and has avoided some of the more extreme, illiquid volatility seen in other G10 currencies. Still, various benchmarks, especially against oil, suggest more CAD weakness is warranted. It has not only undershot the large percentage change in oil this year (refer 1st chart), but from a longer- term NEER perspective, CAD screens rich to the current level of global oil prices as well. The latter would suggest a necessary further downside adjustment of about 5% for the CAD NEER to fully reflect the new low oil price environment.

Fundamentally Canada’s experience in the COVID- 19 crisis is not dissimilar to peers elsewhere, underscoring the global and top-down nature of the current market paradigm. In terms of the spread of the virus, Canada has followed a similar trajectory as Europe and the US, just between 1-3 weeks behind, measured by the population-adjusted death rate (refer 2nd chart). Canada has enacted similar population-wide lockdowns, and the anticipated hit to growth is in the same range: our economists expect Canadian activity to have shrunk 11% by mid-year compared to the US and Europe by 14% and 17% declines respectively.

CAD was also relatedly underpinned by considerable gains in oil, which despite round-tripping of the post- Middle East geopolitical flare-up in the past week, is still 10% higher on net over the last three months. This move lower in the pair sets a higher hurdle for our CAD 2020 view, which has been expecting underperformance, including against the majors like dollar and JPY.

Despite this recent beta-driven CAD strength, the view for underperformance in 2020 on domestic factor still holds amid pandemic Covid-19, though may be less front-loaded than originally expected. This view has been predicated on an expected dovish BoC responding to a broadly-weaker economy, potentially forced to ‘catch up’ to other central banks globally, having earlier eschewed rate cuts in 2019, thereby warranting some catch-up CAD weakness.

OTC Updates and Options Strategy: 

The positively skewed CADJPY IVs of 6m tenors have still been signaling bearish risks, the hedgers’ interests to bids for OTM put strikes up to 72 levels indicating downside risks in the medium terms (refer 3rdexhibit). 

Accordingly, we advocated diagonal options strips strategy to address any abrupt upswings in short-run and the major downtrend.

At spot reference: 76.210 level, buying 2 lots of 3m at the money delta put option and simultaneously, buy at the money delta call options of 1m tenor. It involves buying a number of ATM call and double the number of puts. The option strip is more of customized version of options combination and more bearish version of the common straddle.

Any hedger or trader who believes the underlying currency is more likely to spike upwards in short run but major downtrend can go for this strategy. Cost of hedging would be Net Premium Paid + brokerage/commission paid. Courtesy: Sentry & JPM