FxWirePro: USD/CAD bearish scenarios - 1m well-balanced IV skews signal knock-in options on hedging grounds

The bearish USDCAD scenarios (below 1.28) driven by:

1. BoC indicates the intention to normalize rates earlier due to an improved global outlook.
2. Global demand pushes oil prices to $50 plus and towards $60.

The Bank of Canada has been signaling an imminent rate hike, if not in the July meeting then in September, and this is now priced in. The BoC is giving greater prominence to financial stability concerns stemming from high Canadian household indebtedness and regional housing booms. Although our early 2018 target for USDCAD has been reached, the loonie’s undervaluation should support further appreciation in the months ahead.

In the recent times, CAD vols skews destabilized too much especially on crude’s price sustainability, while USD volatility market normalized sharply (you could observe that in USDCAD IV skews) which has been well balanced on both the sides. The liquidity recovered and the extreme positioning was ultimately absorbed. The price action is not taking the direction of an imminent new trend. As a result, the option market aggressively unwound smile positions.

While the implied volatility remains among the three lowest G10 vols, seeming options globally inexpensive. Despite the recent CAD appreciation, the USDCAD realized volatility has remained muted due to the low realized vol environment which makes knock-out barriers attractive.

Two-month USDCAD absolute moves observed on a daily basis since 2013 has been 88% smaller than the current distance between the spot and the KO barrier (690 pips). This makes the KO event unlikely. Risks are limited to the extent of premium. If USDCAD spot hits the 1.23 barrier at any time before the 2m expiry, the option will expire instantly. Hence, USDCAD 2m put strike 1.27, knock-out 1.23 Indicative offer: 0.20% (vs 0.48% for the vanilla, spot ref: 1.2548).