CAD/JPY Faces A Risky Winter, But Upside Could Be Found As Canada Rebounds

The CAD/JPY currency pair, which expresses the value of the Canadian dollar in terms of the Japanese yen, has been edging its way toward levels that were seen prior to the start of 2020. As stocks began to sour in February this year, the Canadian dollar also started to fall alongside other commodity currencies. Currencies such as the Japanese yen rallied, which was unsurprising to most traders given the reputation of the yen as a conventional safe haven.

From the start of the fourth quarter of 2019 into the first quarter of 2020, CAD was trading against JPY inside of the range of 80-85, with an approximate midpoint being at the 83 handle (as illustrated below). A stronger CAD is in most cases a constructive for risk assets such as equities, especially when set such strength is against JPY.

(Source: TradingView. The same applies to all subsequent price charts presented hereafter.)

From the level of 85 down to the lows in March this year at the 74 handle, the midpoint is around 80, which the current market price for CAD/JPY is perched just above. The question now becomes whether we will see further strength.

Certain commodity currencies such as the Australian dollar and New Zealand dollar were able to retrace their steps back to their previous highs (after also crashing in February and March). These two currencies have already rallied against USD and JPY (both conventional safe havens in their own right). The Canadian dollar has struggled against the Japanese yen, although, interestingly, CAD is currently as strong against USD as it was prior to the emergence of the COVID-19 pandemic which shook financial markets (including FX) this year.

USD/CAD Price Action in 2020

(USD/CAD is now trading at similar levels to 2019; the Canadian dollar has effectively won back all its lost ground this year.)

Two points should be raised. The first is that Australia and New Zealand are net beneficiaries of lower oil prices, while Canada is not; the heavy headwinds for the global oil industry this year have impacted Canada disproportionately due to the country’s export exposures to crude oil. The energy sector has historically represented on the order of 10% of Canadian GDP; direct impacts also create indirect effects (one man’s spending is another man’s income), and therefore, FX markets have rightly viewed CAD with skepticism.

On the other hand, a second point is that CAD has managed to regain all its lost ground against USD in spite of the fact that oil prices are still much lower than where they were at the start of the year (about one third lower). One would assume that suppressed oil prices (mainly due to subdued demand) should, in theory, place pressure on CAD, and indeed, CAD has struggled to gain its lost ground against JPY in spite of heavy fiscal and monetary interventions which have improved risk sentiment massively. Therefore, CAD’s strength against the USD is a better indicator of USD weakness; markets have priced in a lower premium into USD (which remains the world’s reserve currency) due to the fact that the United States is now at the zero lower bound.

The U.S. Federal Reserve’s short-term target rate is currently 0.00-0.25%, while Canada also cut its target rate drastically this year to 0.25% (from 1.75%; a drop of 150 basis points in full). Japan’s target rate has meanwhile held steady this year, albeit still in negative territory, at -0.10%. The spread is therefore positive, but tight, at just 35 basis points (between these two central bank rates). At the time of writing, three-month JPY LIBOR is also negative 10 basis points (i.e., currently aligned with the Bank of Japan’s target), while three-month Canadian CDOR is +50 basis points (two- and one-month tenors carry similar rates).

Therefore, per funding markets, the spread is a little higher for CAD/JPY than central bank targets might imply. Still, the spread is relatively tight. We should not expect lower rates from Japan anytime soon, considering that the country has already felt it unnecessary this year (and a lot has already happened this year). CAD rates may not change further either, although, if they are to change in the medium term, they are likely to fall (no central bank is currently looking forward to hiking).

Japanese GDP fell 9.9% year over year in Q2 2020, after suffering from a 1.8% fall in Q1 2020 and even a modest fall of 70 basis points in Q4 2019 (prior to the current crisis). Japan was already fending off a recession prior to 2020, and it even suffered a technical recession (two consecutive quarters of negative economic growth) in 2018 (see below).

Japanese GDP Change, Q2 2020

(Source: Trading Economics)

Canadian GDP has understandably fallen this year too, and heavily, owing in great part not only to government interventions, lockdowns, and fearful (self-isolating) consumers, but also falling oil prices and similarly unfavorably “terms of trade” developments. As pictured below, Canadian GDP fell 13% in Q2 2020 year over year, although Canada was growing consistently prior to 2020 and was consistently outperforming Japan.

Canadian GDP Change, Q2 2020

(Source: Trading Economics)

Just like Australia and New Zealand (as mentioned), Japan is also a net beneficiary of lower oil prices (being a net-importer). The chart below illustrates indexed terms of trade for both Canada (blue line) and Japan (black dotted line) and shows clearly that 2020 has seen the former collapse and the latter rise. Yet ,we can also see that the rebound in oil prices so far has had a very constructive effect on Canadian terms of trade; markets have responded by ascribing greater value to CAD in FX markets.

CAD/JPY Terms of Trade Differentials in 2020

(Source: Trading Economics)

On the basis of terms of trade and current oil prices (see below for front-month crude oil futures prices), it would seem that CAD/JPY is fairly positioned. Should oil prices remain stable, and should risk sentiment generally hold, it is probable that CAD/JPY will continue higher. There are still significant risks (the current, second wave of COVID-19 could threaten oil demand, especially if it results in significant widespread lockdowns). This is an ongoing risk, especially as we head into the winter months.

CL Futures in 2020

Perhaps CAD is fairly priced versus JPY at present on the basis of these trade-related, sentiment-related factors, and the near-term COVID-19 risk. Without the latter risk, we might expect CAD to steadily continue along its currently bullish trajectory, but I expect a linear recovery for CAD is improbable. I would expect markets to favor either downside or price consolidation through the winter months; should COVID-19 related hospitalizations increase further and significantly in major markets (including the U.S. and Europe), and/or should governments start to bring in widespread restrictions, we should see CAD downside.

Even absent a particularly bearish case, CAD is still unlikely to rebound dramatically into year-end or into the winter months until we are past flu season (January to February 2021 at the latest). Flu season in itself typically results in hospitalizations, and it may be the case that COVID-19 is able to spread more dramatically during the winter season. The backdrop is clearly bad for oil demand in the near term; fear among consumers, even if ultimately found to be unfounded, is bad for oil demand.

CAD is therefore probably not worth buying at present, but provided that the remainder of the year (and the colder months into 2021) does not bring terrible news (with respect to the pandemic), I would continue to hold a bullish view on CAD/JPY in the long term. Canada has historically shown greater economic strength, and has also been able to avoid deflationary risks, with previously the highest interest rate across G10 FX.

Also, if we look to inflation data for Canada and Japan, and if we look back to the central bank rates of these countries, we can adjust the target interest rates for inflation to find an implied real yield (i.e., the interest rate spread adjusted for inflation). Using January 2020 as a base, as of August 2020 (the latest month for data), the real interest rate spread has actually improved in favor of CAD over JPY.

CAD/JPY Real Interest Rate Spread in 2020

In other words, on an inflation-adjusted basis, in spite of CAD rates crashing and JPY rates holding firm, the real yield for CAD/JPY (implied by central bank rates) has improved. This is the power of lower inflation, and it is surprisingly favoring CAD/JPY upside. Not to mention that CAD rates in funding markets are also high, as we saw earlier.

Because of the risks involved, it is difficult to justify being long CAD/JPY during the next few months. However, I would not be surprised by further strength. What I would expect, though, is either price consolidation (largely horizontal price action) and/or downside. A case can be made for upside, but the next few months are rather crucial. Monitoring CAD FX crosses will be worth doing though, as any downside (and/or supportive economic and medical data globally) could provide traders with an interesting long-term long opportunity.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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