The Canadian Dollar Isn't Pricing In an October Surprise

Two potentially high-impact events face Canada's currency.

Traders are eerily complacent about what could prove to be a turbulent October for the Canadian dollar.

On Oct. 19, the nation will hold a federal election that opinion polls suggest is a three-way race. Two days later, the Bank of Canada will release an interest rate decision and its quarterly Monetary Policy Report, which will be accompanied by a press conference.

Alvise Marino, foreign exchange strategist at Credit Suisse, has observed that "option markets do not appear to price in a significant premium for USDCAD topside around the period when these events take place."

That is, relative to other G10 currencies, the implied volatility of USDCAD two-month at the money options is subdued, which means that market participants aren't expecting this pair to fluctuate as much as others over that span:

Credit Suisse

"We think this offers an attractive opportunity to position for a move higher in USDCAD," wrote the strategist.

A closely contested federal election among the three main parties would inspire enough uncertainty on its own, but this is amplified by the nature of the party that currently enjoys a narrow lead: the left-leaning New Democratic Party.

"The NDP’s current electoral platform includes tax rate hikes for large corporations, the imposition of a cap-and-trade system for carbon emissions, opposition to the development of further oil & gas pipelines, and an extensive social agenda," wrote Marino. "This would mark a significant departure from the tight fiscal policy championed by the incumbent conservative administration."

Thomas Mulcair, leader of the New Democratic Party, has pledged that the party will deliver balanced budgets, but economists are skeptical that its plan to raise corporate taxes will generate sufficient revenues to cover its spending priorities.

If the NDP continues its ascendancy in the polls, investors could start to worry more about a Mulcair government's "commitment to maintaining a balanced budget and about potential threats to energy investment, at a time when the sector is already under considerable pressure," wrote Marino.

Meanwhile, the strategist indicated that the Bank of Canada is likely to maintain its benchmark policy rate at 0.50 percent next Wednesday, but that October's status is still very much in play.

Even in an environment in which second-quarter economic data has largely exceeded expectations, Marino noted that the probability of a rate cut implied by the overnight index swaps has, as of late, tracked the price of oil quite closely:

Credit Suisse

"The recent renewed weakness and subsequent rapid rebound in crude prices, driven by developments in China, triggered a similar see-saw pattern in priced-in expectations of further BoC rate cuts," he explained. "We don’t see scope for this relationship to change, and expect uncertainty to remain elevated in absence of a meaningful and significant deterioration or improvement in the growth outlook."

If Brent crude oil makes a move back toward $40 per barrel and the Federal Reserve elects not to raise interest rates in September, Marino believes the Bank of Canada's October meeting would probably reduce the overnight rate for the third time this year.

The strategist has recommended buying a two-month call option for USDCAD to position for upside in the pair because the market does not yet adequately appreciate the potential magnitude of October's events.