Key points:
- Sharp Gains in CAD: The Canadian dollar has surged nearly 3% against the US dollar in August, driven by a dovish shift in the Fed outlook and potential short covering by traders who had record short positions.
- Record Short Positioning: The rally has been partly fueled by short covering, as traders unwound their positions amid the weakening USD, adding momentum to the CAD’s gains.
- Fundamentals Suggest Weaker CAD Ahead: The Bank of Canada’s expected aggressive rate cuts and deteriorating economic outlook could undermine the CAD. Worsening yield differentials, potential USD correction, and technical oversold conditions suggest that current CAD gains might not be sustainable.
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Why is the CAD Rallying?
Fed’s Rate Outlook
At the Jackson Hole conference, Federal Reserve Chair Jerome Powell hinted that rate cuts might begin as early as September, with a particular focus on the worsening labor market. He also left the door open for a potential 50bps cut, which has significantly weakened the USD. This has fueled gains across all G10 currencies, including the CAD. Since early August, when the U.S. July jobs report bolstered the case for Fed easing, the USD has experienced notable weakness. Although the CAD has benefited from this, it still trails behind other G10 currencies.
Short Covering
The CAD rally is partly driven by a wave of short covering. Positioning data from the Commodity Futures Trading Commission (CFTC) indicates that the net short position in Canadian dollar futures may have reached record levels in late July. Traders had heavily shorted the CAD, anticipating a divergence between the easing cycles of the Federal Reserve and the Bank of Canada. The BoC has already cut rates twice this year and is expected to continue easing, while the Fed’s actions were seen as more uncertain.
However, as the U.S. dollar weakened and the CAD began to rise, these short positions became increasingly untenable. Traders who bet against the CAD were forced to unwind their positions, leading to a sharp reversal. This has been evident in the CFTC positioning update for the week of 20 August where net short positioning in CAD dropped from $14bn in the week of 30 July to $12bn. This process, known as short covering, has added considerable momentum to the CAD’s recent strength.
