Analysis from AdvisorAnalyst.com

A Yen for Canada?

Back in September I wrote Canada on the Cusp of Something Big outlining my case about the Canadian economy, markets, and loonie. My central argument then, and now, was that Canadians need to get in front of the "invest in Canada," theme before foreigners do. Sound fiscal policy, strong, well capitalized banks, a productive commodity complex, and our good-old-fashioned brand of conservatism, continue to make Canada the leading destination for investors, both on the domestic front, and internationally, in the G7.

There is more to the Canada story than meets the eye. The fundamentals, are only half the story, and relevant, particularly for the longer term outlook . What matters equally in the near and long term, however, is what is going on behind the scenes in the proprietary institutional and hedge fund trading rooms.

Yesterday, a Bloomberg brief, for example, reported that Citigroup's currency unit recommended buying the loonie and selling yen.

"Investors should buy the Canadian dollar versus the yen because a 'slight appreciation' in the Japanese currency offers a chance to bet against it, according to Citigroup Inc. The bank recommended betting on the Canadian currency from 88.65 yen, with a target of 94 yen, strategists Todd Elmer in New York and Michael Hart in London wrote in a note to clients. That would represent a gain of 6 per cent.

Day after day, we hear that the loonie rose as commodities prices firmed, or the loonie dropped as commodities prices softened. What in fact is going on is that the long positions in the loonie and commodities have something in common, which provides the correlation we hear about. They are both being traded against short positions in currency markets. From March to November 2009 , the loonie, commodities, stocks, and emerging markets were opposite short dollar positions.

As the Japanese finance ministry was forced into quantitative easing to avert a deflationary bust, the Bank of Japan slashed its target interest rates, issuing 3-month bonds at 0.1%, and the yen, which peaked in value in late November, began its now 6-week old correction. With the Japanese economy in crisis mode, the yen appears likely to replace the dollar as the primary carry trade funder.

Short dollar trades which fuelled speculation, bidding up last year's winning trades, will have to be unwound and rolled over. This threatens a correction in risk assets, unless the yen carry rollover progresses at a more rapid pace. In the event the yen carry trade does not rollover at a more rapid pace, it is likely to at least provide support to risk asset prices through the interim, which could be the better part of the year.

Some traders, apparently, do not feel the trades which have supported the recovery rally in the loonie and markets are sustainable in the near term. The International Money Market reported that record short positions were taken out against the loonie.

"Currency speculators made record bets against the Canadian dollar and increased bets against the yen in the week to Jan. 3, moves that trimmed overall positions against the dollar," according to data from the Commodity Futures Trading Commission.

"International Money Market (IMM) speculators cut their net short dollar positions to $6.57 billion, from $11.47 billion the prior week, according to Reuters calculations using contracts in the yen, euro, Swiss franc, British pound, Australian and Canadian dollars. Much of that move came at the expense of the yen. Total net short yen contracts rose to 118,592 from 104,914 the prior week."

On one hand you have Citigroup's currency analysts recommending long positions in the loonie and on the other hand, you have International Money Market speculators betting against it. Who's right?

For the answer, you have to watch the direction of the yen/dollar pair, and the yen/loonie pair. If the yen keeps dropping, the Citigroup call will be right and IMM speculators may get squeezed out of some of their short positions, forcing the loonie higher.

I'm a little sceptical about the sell-side recommendation from Citigroup to be long the loonie. Things are just not that easy. It makes me think they are creating a trade their prop trading desk can liquidate into. If they are right enough, short loonie trades will get squeezed, and the loonie will go higher.

Just take a look at the day-to-day correlation of CAD/JPY vs. the S&P TSX, followed by the CAD/JPY vs. USD/JPY. Day to day activity in equities vs. the CAD/JPY pair is very interesting. Also, note the fact that currency trading session is much longer than the equity trading session, and starts much earlier.

What happens in the last third of the currency session seems to correlate highly to the equity trading session.

Good news in Canada, or the U.S., or, bad news from Japan will tip things higher in the loonie, commodities and other risk assets. They are, after all, more or less on the same side of the trade.

Keep an eye on the currency pairs. Its appears that the Canadian dollar is getting support from foreign investors taking long positions, while the U.S. dollar is being supported by short covering. Odds also appear to favour more bad economic news out of Japan, at least for this year, and perhaps next.