A severe U.S. dollar undervaluation is now likely to lead to a substantial improvement of the U.S. Balance of Payments through continued strong export performance. My trading thought is to buy USD/CAD at 1.05 for 300 pips in profit potential.

The Canadian dollar has been particularly strong over the past two weeks. Yet, the recent spike in volatility looks more like profit taking than like the beginning of a new down trend. Indeed, I expect more dollar strength going forward. First, a severe U.S. dollar undervaluation is now likely to lead to a substantial improvement of the U.S. Balance of Payments through continued strong export performance. Second, with the world economy slowing down is reasonable to think that the demand for commodities will also begin to slow down. As a result of this, commodity sensitive currencies like the Canadian dollar, Australian dollar and New Zealand dollar will be particularly vulnerable. Finally, a significant shift of interest rate expectations in favor of rate hikes by the Federal Reserve is likely to help the U.S. dollar to rally further.

Canadian Economy Fundamentals

The once immune Canadian economy has recently joined the list of economies that have been hit by the mortgage debacle. At the onset of the mortgage meltdown, the Canadian economy was faring well, with consumers remaining optimistic about the performance of the economy. Fast forward four to six months later, and the once resilient consumer confidence has been crumbling under the pressure of declining housing market and weak labor market. Moreover, businesses find it increasing difficult to remain optimistic on the back of tighter lending conditions and declining demand from domestic and global consumers alike, largely due to a strong currency.

Canadian Dollar Forecast

My thought is to buy USD/CAD at 1.05 for 300 pips in profit potential with a stop in a daily close below 1.03. Indeed, higher interest rates could make the U.S. dollar more attractive to foreign investors and the higher level of demand for assets denominated in dollars could accelerate gains in the USD/CAD.

Antonio Sousa is a Currency Analyst for FXCM.