USDCAD is back down below the 1.45 level this afternoon and has seemingly found firmer footing that historical support levels going forward.
Previously, as markets went into meltdown in the hunt for dollar liquidity and oil markets also felt the brunt of the risk-off wave, the loonie clung onto its 2016 low support level, failing to breach it on both Wednesday and Thursday’s session. However, despite the currency pair leaning on the support level to stem a potential rout in the currency, the loonie still has a lot more in its chamber to fend off further downside pressures.
The wave of measures taken by the Fed is beginning to take some of the edge off of the greenback. Enhanced swap lines to major central banks and increased operations to pass the dollar liquidity onto local banks in key economies has taken some of the funding costs out of cross-currency basis swaps.
This is most notable in JPY-USD 3M3M basis swaps which fell from a premium of 135.62 only last Thursday to 104.5 today.
While the cost of dollar liquidity in FX markets still comes at an elevated premium, it shows the elementary signs that the Fed’s swap lines are working. The Bank of Japan has pumped over $150bn into its financial system, with almost $90bn taken up in today’s auction alone. The 84-day operation this morning saw Japanese banks take $73.8bn in USD liquidity at a cost of 0.35%, substantially below the 2% charged in FX markets, while the remainder of the headline figure was taken in its 7-day offering.
Further liquidity operations have tempered US dollar demand in FX markets with the ECB allotting seven banks $4.1bn in 7-day operations today, compared to just $20m today, while $3.6bn was taken from the Bank of England, up from $5m on Monday. The 7-day liquidity measures are set to continue at a daily rate with the 3-month auction taken at less frequent intervals. While the international swap program has taken some of the edge off of the greenback, the Bank of Canada is yet to extend its swap line with the Fed into its domestic banking market, suggesting further CAD support can be found via this avenue.
“Following the previously announced Coordinated Central Bank Action to Enhance the Provision of Global US Dollar Liquidity the Bank is announcing that it intends to launch a USD Term Repo Facility, should the need arise.” – BoC press release March 20th.
Graph: Premia on cross-currency basis swaps sits near last weeks highs but has tailed off somewhat, even in CAD despite lack of BoC action
Arguably, the BoC’s reluctance to extend cheaper dollar liquidity into its financial system is because the Governing Council are happy with the current level of loonie weakness.
Such a stance by the central bank would run in line with our reading of monetary policy during Q3/Q4 2019. During this period, we believe Governor Poloz and the Governing Council were content with the weakness in the loonie for the most part as it gave them breathing room to avoid an insurance rate cut. Every time the Canadian dollar showed bouts of strength, members of the Governing Council took to the wires and talked it down with dovish commentary.
Now, with the focus of monetary policy being directed firmly at quelling credit strains within domestic financial markets, the BoC is happy to allow USDCAD to trade at elevated levels. This comes in spite of the premium for USD liquidity in FX markets sitting near multi-year highs. Arguably, however, if another swathe of USD strength comes to the fore, the Bank of Canada may be forced to intervene in FX market by supplying USD liquidity. This would add additional support to the loonie besides that of charting technicals.
This scenario could likely play out in the near-term…
While markets have had a breather today, it wouldn’t be wise to call the end of the US dollar just yet. Markets still await the release of key economic data from developed economies which would likely prompt risk-off flows into the dollar if the economic damage is greater than the market base case. Additionally, further harsh containment measures are likely to be installed and could be in place for longer than initially expected. This would only increase the probability of deeper recessions than anticipated occurring.
Finally, both quarter-end and fiscal year-end approaches, which in normal environments sees a steady flow of demand into the dollar. Additionally, as opposed to last week, oil markets seem to be in much better shape given the supply of dollar liquidity by the Fed the widespread announcements of sizeable fiscal stimulus measures underpinning demand conditions.
Author: Simon Harvey, FX Market Analyst