I hope everyone had a wonderful Christmas and continue to enjoy the holiday season. I am in a bit of a pie coma from yesterday as I enjoyed a slice of key lime, apple, pumpkin, and chocolate yesterday. It is okay, you should be judging me. With that in mind, this post will be a bit unstructured and scattered as my body and mind recover from yesterday's sugar sins.
The long USDCAD trade continues to be my favorite trade on the planet and it still holds my highest conviction. The loonie much like Canada itself is not sexy to trade and recieves very little attention from traders or the media and I quite like that. Just in google hits on EURUSD for example, the number is about 4x what USDCAD garners. Everyone is talking about the yen and euro and yuan and rightfully so, the FX markets have been the one actually reflecting some macro reality lately. With that said, shorting the loonie continues to shape up as a blockbuster in my view. Why? Well let's dive in shall we.
Ah yes, surprised economists...
In a move I would not classify as surprising, the Canadian economy contracted in the past quarter and could be at risk of an official recession as we move forward. I have talked about many headwinds in Canada that I expect to hurt the economy on this blog including trade, energy, and policy but today, I want to focus on housing. I have mentioned the housing bubble in Canada in previous posts about my loonie thesis, but more so as an odds enhancer - a built in asymmetric lottery ticket if you will. Today I want to look at this bubble a little closer as I begin to view it as more of an eventuality that will attach a rocket booster to USDCAD than as a lottery ticket with lottery type odds. I have avoided focusing on housing heavily because the timing of bubbles bursting is so difficult and I would never place a currency trade based on trying to time one. With that said, this bubble gets closer to bursting every day and the data continues to deteriorate. As long as the rest of the drivers for a lower loonie are present and we can stay in this trade, the odds of this lottery ticket hitting pay dirt for this trade grow.
Let's start with a video the BOC just released on just this topic. At least these guys think about it and do so publicly. I do not remember the Fed doing anything similar. My personal favorite part of this video is when the gentlemen puts our fears at ease by citing a stress test. That boosted my mental model returns as soon as he said that. That is sure to be another "surprise" to the economists.
The video mentions highly indebted households. I would personally use the word extremely as Canadians passed "high" debt levels a long time ago. This debt is extremely levered to housing, much like the entire Canadian economy and financial system is. Hell they even have a shadow lending system where home owners take out HELOCs only to lend the cash to other house speculators who cannot get financing. That will surely end well...
Let's take a look at some charts.
Pretty bad right? Well how does that stack up to our own bubble a decade ago? Ouch...
Hopefully this sheds some light on just how big this bubble is and just how leveraged the population and the Canadian economy and government are to housing. But as we know, this bubble can keep going well past any logical or reasonable period before it finally bursts. Canadian debt and leverage associated with housing and its share of the economy can continue to grow and may not impact this trade for a long time. Shorting the loonie could even cease to make sense as a trade before this bubble bursts. But...if it does crack, this trade becomes a real wealth building trade. The good news is, this trade has been paying us to wait recently and we just got a raise on that paycheck with the Fed raising rates this month. Considering the growth and policy divergances between the US and Canada, I expect further raises in the future. I would hold this trade without positive carry, so I am very happy to hold it with a positive carry that is growing and could grow much more in the year ahead.
As of right now with US rates at .75 and Canadian rates at .50, holding one standard sized lot long USDCAD is netting you roughly $20 per month. Just one US hike and one Canadian cut (each 25 bps) would triple the positive carry to roughly $60 per month in income on one lot. This great fundamental trade is offering a positive carry that is trending upward and could continue to trend much higher if Canada enters a recession and/or housing finally collapses. The BOC response would triple the current positive carry if Canada moved to zero on their policy rate, and even higher if they had to go negative. That is without any further rate hikes in the US. If Canada had to go to zero and the dot plot actually came true and the Fed raised three times in 2017, the positive carry on one lot would be worth roughly $120 per month. An investor with 10 lots would make roughly $15k being long USD/CAD in interest income per year at that point. While I think the carry income will grow in 2017, I doubt the Fed raises three times. I would expect US rates to be at 1 with Canada at .25 at the end of the year which will triple interest income. With Canadian GDP currently in contraction however, we may see Canada move to zero this year further boosting income from this trade.
Considering that the Canadian economy is more levered to housing than energy and the loonie was massacred by energy in the past couple of years - when the housing bubble pops, the loonie will be in a positive carry free fall.
A few of my charts are from this outstanding work by Seth Daniels who runs the leading firm on Canadian housing shorts in my view. Check it out here. He also gave a great interview on this topic and more here.
Scroll through and check out my previous posts about the loonie and below are some obligatory charts.