Last week, the Bank of Canada decided to hold interest rates steady as a part of its Monetary Policy Report. The headlines looked nondescript, and the Canadian dollar (FXC) barely budged in the wake of the announcement. I almost missed the important underlying details, but a plunge in USD/CAD caught my attention. By the time I realized that the move was part of a day of significant weakness for the U.S. dollar (go rate cut cheer!), I had already started examining what the Bank of Canada had to say. I am glad I did. The BoC's message was revealing and a refreshing examination of risks in financial markets.

The BoC created a stark assessment of the skewed risks presented by the U.S. trade wars. The BoC estimated large hits to global and Canadian GDP, 3% and 6% respectively through 2021, in the worst case scenario of an escalation of protectionism. The upside scenario of a complete rollback of tariffs would only deliver a 1% gain for global GDP and a 2% gain for Canadian GDP through 2021. The significant downside risks come from a slowdown in global trade, heightened economic uncertainties, and, perhaps most importantly, the inability of central banks to lower rates enough to combat the downside economic impacts. A prime impediment to fighting the downside risks of a global trade war comes from the upward pricing pressures that would be in place as global supply chains shrink in capacity. The Bank of Canada marveled at the market's willingness to believe in the rosiest of outcomes of these looming risks.

While bond markets are pricing in bad outcomes for global and domestic growth by sending long-term yields downward to recession-like levels, stock markets are celebrating the resulting pressure on the Federal Reserve to lower interest rates. The result is a truly bizarre situation in the U.S. of rate cuts accompanying historically low unemployment and a stock market at all-time highs.

Despite the pressures on the Federal Reserve, the Bank of Canada made it clear it does not need to follow suit in this latest race to the bottom for monetary policy. Specifically, the BoC noted that its rates are already low in response to a recent "rough patch" in the economy. The Canadian economy is in a recovery from that weakness whereas the U.S. economy is coming off the highs of extra stimulus. The resulting convergence in monetary policy and economic outlooks is the trading opportunity for going long the Canadian dollar against the U.S. dollar. 

USD/CAD last peaked at the end of May. The currency pair closed last week at a 9-month low. While this setup makes the Canadian dollar sound expensive, it is important to remember that the Canadian dollar is still suffering the lingering impacts of the big sell-off in oil the climaxed in early 2016. The following long-term, weekly chart shows the large downside opportunity remaining for USD/CAD in a scenario of convergence.

I cannot estimate an "equilibrium" level for USD/CAD after the process of convergence ends, but I am comfortable assuming it is somewhere much lower than current levels. At current levels, USD/CAD is still close to the top of a recent trading range. With the Federal Reserve lowering rates, the small penalty of carry will also trend downward over time.

Granted the downside risk is significant in the case of a global economy burdened by trade wars. The Bank of Canada estimated a 25% reduction in the value of the Canadian dollar in the worst case scenario. I hope to mitigate this risk by stopping out USD/CAD above an important technical level such as above the downtrending 20-day moving average (DMA) in the most conservative trading approach or the converging 50 and 200DMAs in a more standard approach. This method of course assumes the market will not suddenly and abruptly price in the worst case risks in a single collapse. I hope to have other hedges in place for THAT kind of calamity!

Be careful out there!