The loonie could be in for a rough ride tomorrow

The Canadian dollar is losing steam as investors bet that the Bank of Canada won’t do enough tomorrow to keep the currency aloft

Currency traders who have driven the loonie to a 10-month high are buying protection against the risk of a letdown from the Bank of Canada.

Image credit: National Post

With the central bank looking poised to raise rates Wednesday, investors are betting a hike might not be enough to sustain the currency’s strength. They’re piling into options contracts protecting against declines, just in case the central bank decides not to pull the trigger. Of 30 analysts surveyed by Bloomberg, 22 expect the bank to tighten this week.

One-week risk reversals on the pair, a measure of options positioning, have risen to their highest since January in the run-up to the meeting, signalling concern that the loonie has risen too far, too fast. Traders have accumulated more than $2 billion of call options giving them the right to sell Canadian dollars if the currency weakens to the 77.22 to 75.75 U.S. cent range, Depository Trust Clearing Corp. data show. The loonie was little changed at about 77.50 U.S. cents Tuesday morning. It’s the best-performing Group-of-10 currency in the past month.

“Given the swift move in the loonie over the past few months and the degree to which Bank of Canada hikes are priced into the market, the demand for shorter-dated calls suggests the need for protection in case there’s profit-taking after this week’s meeting,” said Bipan Rai, senior foreign-exchange and macro strategist at the Canadian Imperial Bank of Commerce.

He predicts the BOC will boost borrowing costs this week and potentially follow up with another hike this year. Rai sees the currency stabilizing after the meeting, on the expectation that the central bank will probably cite uncertainties to the nation’s inflation outlook.

“That should keep some elements of a dovish hike in place and provide some semblance of calm to the CAD following the initial volatility,” he said in a July 5 report.

Swinging Sentiment

The market-implied odds that the central bank raises rates on July 12 are at 94 per cent, up from just 5 per cent a month ago, according to trading in overnight swaps.

Policy makers’ comments triggered the swing. BOC Governor Stephen Poloz and Senior Deputy Governor Carolyn Wilkins jolted markets last month with talk of tightening. On Friday, data showing faster employment growth solidified the view that the central bank will hike.

One-week risk reversals, which help quantify the appetite for protection, are trading above three-month risk reversals for the first time since the U.S. presidential election triggered a rally in the U.S. dollar. That crossover has only happened three times in the last seven years, suggesting investors are preparing for a potentially extreme event.

“The market is leaning short USD/CAD and buying cheap insurance in case the BOC fails to deliver,” said Mark McCormick, North American head of foreign-exchange strategy at Toronto-Dominion Bank.

He expects the central bank to stand pat, leaving room for the exchange rate to stall, because in his view traders are pricing in too much tightening from the BOC.

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