FxWirePro: Fair elucidation of BoC policy normalization, owning topside convexity and bidding USD/CAD costless call spreads

After a several month long cycle of policy repricing that culminated in outlier back-to-back policy rate hikes in July and September, CAD has seen some understandable consolidation.  The 4% USDCAD retracement since 8 Sept is largely a convergent policy repricing of the USD towards CAD (which still has 18bp more tightening priced in than the US), rather than an unwind of the monetary bullish shift that had driven CAD’s repricing (CAD 2y yields are flat in the month).

The key call behind CAD outperformance view that BoC continues to signal a framework that implies continued steady normalization towards neutral policy, something that October’s quarterly Monetary Policy Report should help confirm.  Our read of BoC’s new policy framework behind its recent hikes is one that:

i) Notes that the output gap is imminently fully closing now;

ii) The policy acts with a long lag and a closing output gap makes it incumbent to be working towards normalization today;

iii) The strength of recent data confirms that the drags from the earlier terms-of-trade shock have passed.

Buy USDCAD 3m risk reversal strikes 1.2850/1.22 Zero cost, (indicative, the call strike 1.2850 costs 0.5%, spot ref: 1.2630).

The recommended risk reversal structure takes direct advantage of the cheap skew opportunity.

We expect any CAD downside has to be volatile, as it would likely be caused by geopolitical tensions and/or market unwind.

This justifies owning topside convexity and volatility. Pure volatility investors may implement active delta-hedging to get direct exposure to the skew while getting rid of the directional risk.

Given the downside risks attached to CAD appreciation, we would advise directional investors to implement a delta-hedging strategy involving a negative pre-defined mark-to market threshold.

Risk profiling: Unlimited below 1.22 Investors face unlimited risk if USDCAD trades below the 1.22 strike in three months.

Currency Strength Index: FxWirePro's hourly CAD spot index has been weaker after last Friday’s feebler Canadian CPI and retail sales data (actual 0.2% versus forecasts at 0.3% and -0.7% versus forecasts at +0.3% respectively), inching towards -20 levels (which is bearish), while hourly USD spot index was at shy above 150 (highly bullish) at the time of articulating (at 10:00 GMT). For more details on the index, please refer below weblink:

http://www.fxwirepro.com/currencyindex

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