The recent sell off in commodities perhaps has created the catalyst for the CAD to depreciate. Being long the CAD has been a trade that...

... commenced in the beginning of 2002 when it was trading at 1.6190 to the USD. At the same time the CRB dipped to 190.

Currently, the USD/CAD is at 1.15 and the CRB is at 315. This report presents the case that the USD is cheap against the CAD and at current levels there is an opportunity to sell CAD against the USD. The initial target is 1.20 then 1.25.

So why do we think the CAD is expensive?

In this note we will focus on the Fundamental and Technical picture for the trade as it is rare that when combined the picture for selling the CAD is well defined. In addition, given that predicating the future is encased with imponderables we have a clearly defined exit strategy in place should our analysis be incorrect.

Fundamentally

As you can see from the chart below of the CAD overlaid with the CRB, has appreciated in line with the growth of the commodity markets, in particularly that of Gold and Oil. The Canadian economy has flourished as companies associated with the rise have cashed in on supernormal profits.

In turn, investors have turned to the CAD or CAD assets for returns. In order for the CAD to continue to appreciate we have to decide whether or not current prices for commodities are sustainable and whether or not current demand for these commodities remains buoyant.

CRB vs USD/CAD




Are Commodity prices at current levels sustainable?

Current market forces are telling us that highs for some commodities might be in place or that we are about to enter into a period or consolidation that will see Oil, Gold and Base metals to trade to more realistic levels.
Oil for instance at the end of January reached a high of US69.20 on the back of geopolitical concerns in Iran and Nigeria that had potential to restrict global supply of the commodity. However, as the market is currently running a surplus of 1.2mio barrels a day (which is expected to grow through out 2006-07) and with traditional winter demand abating we expect prices for oil to remain relatively soft for a while to come, that is given no major imponderables occur.

On the metals front, Gold rejected 574 with a vengeance and has tried to rally off 550, yet ran out of steam at 564. Currently, it is eyeing support at 537 and with the lack of inflationary pressures and geo political concerns Gold’s shine will be tarnished for a while. On this front we can expect more of a shake out before good value buying occurs.

Base metals, as indicated by the LME Index over the last twelve months have rallied by 46% have stalled and just recently we have seen massive liquidations on the back of profit taking.

This price action for Oil, Gold and Base metals concludes for many that these markets have entered into a period of consolidation. Is this sell off a precursor to value and telling us that demand is just starting to wan?

Is demand for these commodities sustainable?

The key to this question rests with the consumer; after all it is he that is at the end of the production line. His ability to consume sets the pace for growth and with primary in put costs of raw materials more than doubling in some circumstances, we have to question his commitment into paying up.

A good way to do this is to examine forecasts for Gross Domestic Product (GDP) per country. GDP is a key driver to questioning the sustainability in a countries growth. It is the total value of all goods and services produced within a country. It helps confirm for many the state of which the economy is in, expanding or contracting.

Currently, Fourth Quarter GDP in the US showed the economy growing at its slowest rate since 2001. The economy managed to expand at a 1.1% annual rate. This snapped the 10 straight quarters of growth, which showed growth exceeding by 3%. In the same Quarter consumer spending, which accounts for about 70% rose by a marginal 1.1%, when compared with the twenty-year average of 3.4%, it is a major shift in confidence.

In addition, personal saving rates for the same period declined for the first time since 1933. It presents an ominous picture in particularly as we are still amongst an interest rate tightening cycle, which has been reconfirmed by the FEDs new Boss: Bernanke.

In the US we expect to see GDP continue to shrink and domestic demand for commodities to taper off. The only panacea to sustaining demand would be from those new infrastructure-starved economies still experiencing significant growth for commodities such as China and India.

Both economies have been averaging exceptional growth rates and many are tipping for this to continue into 2006. However, in the same breath economists are saying that growth will not be as robust post 2006, sighting high prices and changing interest rate cycles as a major cause for contraction both domestically and internationally.

GDP in China according to the State Development and Reform Commission is expecting growth to drop back to 8.5% however; analysts suggest that GDP growth will continue to be strong ranging between 9 and 10%.

Many investors, hedgers and now fund mangers are expecting growth to continue and so have taken advantage of the current tightness in the supply of many metals by remaining long.

Even if growth is higher and demand continues can “the engine room of the world” then on sell any over capacity? A recent example in the steel industry could be a precursor of things to come for other metal markets and present a concern that needs to be monitored.

According to the National Development and Reform Commission the steel sector is “facing a grimmer outlook for 2006” than what was presented in 2005.

Production capacity hit 470 mln tonnes by the end of 2005 that is 120 mln tonnes higher than what was demanded by the market and they have an additional 70 mln tonnes under construction with another 80 mln tonnes awaiting construction. Given the surplus production it would be interesting to see if the export market will soak it up and from where or will we see “fire sales”.

Looking at the current global supply/demand for Oil and metals if China is looked at to lead demand, then as in the steel market, perhaps the consolidation period we have entered into may just last a little longer. Remember raw materials are purchased for fabrication, however, if no one needs the end product then what happens to prices? They fall.

Given the above we are finding it difficult to find a motive to initiate commodity backed currency trades at these levels and have singled out the USD/CAD as the best investment opportunity for sometime. Why? We have briefly focused on four major reasons as to why we think the CAD will depreciate:

The US is Canada’s major trading partner contributing 82% of exports in doing so the US economy must be a barometer for Canada. If the US economy is off the boil so will demand for those commodities that the Canadian economy provides. As it stands commodities make up over 35% of Merchandise trade for Canada.
As interest rates in the US continue to rise expect economic activity to continue to slow down and so to demand for commodities, in particularly from Canada. Only recently the Bank of Canada issued a statement to the effect that it would also start moving interest rates higher. Thus expect the domestic economy to slow down as well and expect foreign investment flows to start exiting the country.
We are currently seeing a big shake out in Oil, Gold and Base metal prices. This has signalled to many investors a change in the fundamental out look for commodities and questioned the extent of the boom continuing. The moves have put in place significant highs, which will need time to consolidate before breaking.
It is perceived that Asia will pick up the slack from the US if the US economy continues to shrink however given our example in steel perhaps this is not the panacea the market is looking for.
So given the fundamental outlook for the CAD does not look all that positive. Does the Technical side of the trade add weight to our negative CAD outlook?

The CAD has been in a major uptrend against the USD, it commenced at the end of January 2002, at a level of 1.6186. It reached a low 1.1375 on the beginning of February 2006. We will use 1.1370, as the low and the area if broken where we would have to review our strategy. As long-term momentum indicators are showing divergence we suggest that a low of significance is now in place.

Major trend line resistance of the move from February 2003 stands at 1.1670, on a daily close above this level we will conclude that the correction of the trend is under way. Our first target above 1.1670 is 1.20 then 1.25. We are viewing this trade as a long term play.

The weekly chart below suggests a base of significance is forming.





To take advantage of this trade we are looking at the spot market USD/CAD market as the interest differential is in our favour. If looking at options currently volatility is low so you are buying options that are of good value.


Jonathan Barratt BEc| Head of FX and Metals | Tricom FX & Metals
Ph +61 2 8274 6121
Ph 1300 732 288
Fax +61 2 9251 6331
jonathan.barratt@tricom.com.au
http://www.tricom.com.au/