The US Dollar is experiencing a rally for the second consecutive day due to robust US data, including strong business activity and Jobless Claims. These developments support the Federal Reserve’s stance of maintaining interest rates, boosting US Yields and the US Dollar.
The USD/CAD pair is trading at 1.3670 after reaching an intra-day high of 1.3780, despite a 0.3% decline on the weekly chart. The trend appears bearish, but recent higher lows suggest the pair may have stabilised.
Optimism Around The Federal Reserve
Optimism around a hawkish Federal Reserve is bolstering the USD. Recent US data showed improvements in the services sector, overshadowing a decrease in manufacturing activity and affirming a resilient labour market with reduced Jobless claims.
The Canadian Dollar remains weak following a 1.1% decline in May retail sales, which aligns with market forecasts but raises possibilities of a rate cut by the Bank of Canada. This data negatively impacted views on potential rate changes at the Bank of Canada meeting next week.
In understanding the Federal Reserve’s impact on the US Dollar, its primary roles include adjusting interest rates to manage price stability and employment. Quantitative Easing typically weakens the US Dollar, whereas Quantitative Tightening tends to strengthen it.
Given the policy divergence, we believe the primary trade is to position for further USD strength against its Canadian counterpart. The robust US data provides a solid foundation for a hawkish monetary policy stance. This contrasts sharply with the economic situation north of the border.
Canadian Economic Indicators
Our view is strengthened by recent statistics not mentioned in the initial report. The S&P Global Flash US Composite PMI for June surged to 54.6, a 26-month high, while weekly jobless claims remain low at 238,000, confirming the narrative of a resilient American economy. This gives the monetary authorities little reason to consider lowering borrowing costs soon.
Conversely, the case for Canadian weakness is building beyond just retail sales. Canada’s annual inflation rate cooled to 2.7% in May, and the central bank already initiated a rate-cutting cycle with a 25-basis-point reduction on June 5th. We see a high probability of another cut at the July 24th meeting, which will continue to weigh on the currency.
For derivative traders, this environment suggests buying call options on the USD/CAD pair. This strategy provides exposure to the expected upward movement while capping potential losses to the premium paid. It is a direct and risk-defined way to act on the differing outlooks for the two economies.
Historically, periods of significant policy divergence have led to sustained moves in the currency pair. Between 2014 and 2016, as the US prepared to tighten while Canada was easing, the pair rallied over 30%. While we do not expect a move of that magnitude, it serves as a powerful precedent for the current setup.
Volatility is likely to increase around upcoming data releases and central bank announcements. Therefore, we also see merit in using option spreads, such as a bull call spread, to reduce the initial cost of the trade. This allows for profiting from a moderate rise in the pair while providing a more cost-effective structure.
