So Close, Yet So Far Away
Canada and New Zealand. Countries on different sides of the globe. On opposite sides of the equator even! Yet, their currencies tend to run close together.
The reason for the correlation is due to the fact that the two currencies are both those of commodity-rich countries. We posted a similar story yesterday about the correlation between the Australian dollar and the “kiwi” (New Zealand dollar). This relationship makes more sense, given the geographical and economic relationship between Australian and New Zealand. But the fact of the matter is that the “loon” (Canadian dollar) has a strong correlation to the currencies of these two countries as well.
Although the loon and the kiwi normally trend in the same direction, the New Zealand dollar has outperformed the Canadian dollar for the last couple of years. The Kiwi stayed in a trading range in 2013 while the loon steadily declined. Both currencies dropped in 2014 and through most of 2015. But the kiwi bottomed out last September while the loon didn’t put in a bottom until January.
Back in early 2004, the spread Canadian dollar/New Zealand dollar spread bottomed out at a multi-year low of 611-basis points. This means that the loon was priced at just over six cents more than the Kiwi. This proved to be an historic low. The spread initially bounced for a few months, retreated to 6.68 cents by the spring of 2005, and then rocketed to just over 29 cents by the summer of 2006.
The loon’s fat price premium became the ‘new normal’ as it consistent made run-ups to 28.5 cents or higher in 2007, 2008, 2009, 2010, and 2011.
Things changed in the second half of 2011. The loon/kiwi spread broke out of the bottom of the multi-year trading range and began a multi-year descent.
By the first quarter of 2014, the spread tested and broke the 2004 low of 6.11 cents. This put the difference between Canadian dollars and New Zealand dollars at the smallest price in a couple of decades!
After the three-year slide from the early 2011 top to the early 2014 bottom, the Canadian dollar/New Zealand dollar spread stabilized and built a trading range. The price boundaries of the last couple of years have defined an obvious support level.
On the daily timeframe, the nearest-futures loon/kiwi spread established a record low of 3.87 cents on March 18, 2014. It then rallied 8.53 cents over the following six months.
The spread headed south again and established a low of 3.97 cents on March 23, 2015. This was the launching pad for a 9-cent rally that lasted for three months.
By just a fraction of a cent, the spread posted a new record low of 3.81 cents on December 28, 2015. Unsurprisingly, a reversal quickly followed. The loon/kiwi spread rallied slightly more than seven cents over a four-month period.
You Are Here
One week ago, the Canadian dollar/New Zealand dollar spread closed below the 4-cent mark for the first time in 2016. The low of the move (so far) was posted at 3.96 cents just three days ago.
The spread bounced sharply on Wednesday and Thursday, closing at 5.7 cents just yesterday. Heck, it even touched 6.5 cents on an intraday-basis earlier this morning! Based on the price range and the behavior patterns of the last couple of years, it seems that this should be the start of a multi-month rally for the loon/kiwi spread.
How to Play It
Over the last several years, the 75-day Moving Average has done a pretty good job of confirming both the uptrends and the downtrends in the Canadian dollar/New Zealand dollar spread. The catch, of course, is that a moving average is a lagging indicator.
The lag characteristic of a moving average is normally not a problem. This is especially true if the market has still been able to continue its trend long after the crossover above/below the moving average. This is why I often use moving average signals to enter/exit spread trades.
But there is a problem this time around. You see, the moving average is currently located at 8.18 cents. That’s a whopping 248-basis points above yesterday’s closing price. Yikes! So waiting for a close above the 75-day MA to get long would leave a lot of money on the table.
So here’s my solution: Look for a setup to get long somewhere down here. In other words, do some bottom fishing. Then use a close above the 75-day MA as a green light to start pyramiding. That way you’d already have an open profit to provide a nice cushion when the loon/kiwi spread finally clears the 75-day MA.
So now we have to figure out a way to get long down here. Looking at how it played out the last three times, I offer these observations and thoughts.
After the March 2014 bottom, the spread rallied 1.67 cents and closed at 5.54 cents. It then pulled back 86-basis points to close at 4.68 cents. This retraced 51% of the initial bounce.
After the March 2015 bottom, the spread rallied 1.51 cents and closed at 5.48 cents. It then pulled back 118-basis points to close at 4.30 cents. This retraced 78% of the initial bounce.
After the December 2015 bottom, the spread rallied 1.66 cents and closed at 5.47 cents. It then pulled back 142-basis points to close at 4.05 cents. This retraced 86% of the initial bounce.
Based on this pattern, it seems reasonable to expect a pullback after this initial bounce. Furthermore, buying a pullback below the 5-cent level and risking to new closing lows could be a low-risk way to throw a line in the water on the long side of this spread. Once the uptrend is confirmed via a close above the 75-day MA, the position could be pyramided.
Place a hypothetical order to buy one September Canadian dollar contract and simultaneously sell one September New Zealand dollar contract at a spread of 4.75 cents (premium Canada). If filled, the spread will initially be liquidated on a two-consecutive day close below 3.75 cents.