Canada's Biggest Bank Says Fund Your Carry Trades Through Loonie

  • Canadian dollar replaces euro in carry role, RBC says
  • Adds to argument biggest capital outflow in G-10 may persist

Investors looking to buy the high-yielding currencies of Australia, Indonesia or South Africa should start by shorting the Canadian dollar.

So says Royal Bank of Canada, the nation’s biggest lender by market capitalization and the most accurate forecaster of its currency in the first quarter, according to Bloomberg rankings.

The bank says conditions are right for one of the $5.3 trillion foreign-exchange market’s most reliable money makers -- the carry trade, which involves borrowing in a low-interest-rate currency and investing the proceeds where yields are higher. The move is tantamount to shorting the funding currency, or betting against it. After the collapse in oil prices over the past year and two interest-rate reductions by the Bank of Canada, the nation’s currency has replaced the euro as the best source of funding, according to RBC, which ranks second among Canadian banks behind Toronto-Dominion Bank in terms of assets.

"Since the Bank of Canada started cutting rates, that lowers the hurdle for the Canadian dollar being a good funding currency," Adam Cole, head of global foreign-exchange strategy at RBC, said from London. "I would expect to see capital flowing out of Canada to currencies and assets that have similar risk properties but higher yields."

Cash Exodus

Money is already leaving Canada at the fastest pace in the developed world, according to Bank of America Merrill Lynch data. The currency’s role on the losing end of the carry trade provides another reason for it to stay weak, even as it hovers near an 11-year low, according to Cole.

The loonie, as the Canadian dollar is known for the image of the bird on the C$1 coin, fell about 0.1 percent to C$1.3287 per U.S. dollar as of 10:23 a.m. in Toronto on Monday. It reached a two-month low of C$1.3318 Friday. One loonie buys about 75 U.S. cents.

At 0.5 percent, Canada’s benchmark interest rate is higher than those for the euro region, Japan and the U.S. Yet the fact that the BOC has reduced its target by half since January raises the loonie’s appeal as a source of funding.

Traders are pricing in that the Bank of Canada will keep its benchmark rate on hold through at least the first quarter, while there’s about a 70 percent likelihood that the Federal Reserve will boost its benchmark next month, according to Bloomberg calculations based on overnight index swaps.

One benefit of the loonie is that Canada’s resource-focused economy is similar to those of the higher-yielding currencies that the carry trade would target. That means the loonie tends to rise and fall along with them, limiting the risk that Canada’s dollar would surge and wipe out returns.

Canada’s dollar is the best way to fund these trades against fellow commodity exporters such as the Australian and New Zealand dollars, the Chilean peso and the South African rand, according to RBC.

The subdued growth outlook for Canada also protects carry trades, Cole said.

The Canadian economy may expand 1.1 percent this year and 2 percent in 2016, according to forecasts compiled by Bloomberg. The U.S. will probably grow 2.5 percent in 2015 and 2.6 percent next year, the survey shows.

"If we were bullish enough on Canada to start contemplating higher rates, that would clearly have the potential to nullify the status as a funding currency," Cole said. "We’re a long way from that."

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