Traders have amassed their largest net-long position in the Canadian Dollar since 2012 but this is now at risk from softening economic data, a go-slow Bank of Canada and uncertainty over NAFTA negotiations.

Risks to the Canadian Dollar remain to the downside over the medium term, according to economists, who forecast turbulence ahead regardless of what happens with the drawn-out NAFTA negotiations in the New Year.

This is more good news than it is bad for overseas buyers of the Canadian Dollar as it could mean a continuation of a recent trend that has seen the Loonie give up earlier gains to the Pound. After a torrid nine months, the Pound-to-Canadian-Dollar rate is now unchanged for 2017 as a whole.

“Economic readings are already turning, but that hasn’t dashed market talk of another Bank of Canada rate hike. Investors are still attaching a 40% probability to further monetary tightening this year,” says Avery Shenfeld, chief economist at CIBC Capital Markets.

Since the end of June, traders have steadily built the largest net-long position seen in the Canadian Dollar since 2012 in response to two back-to-back rate hikes from the Bank of Canada and mounting expectations of more to come.

“While that pricing limited the damage to the loonie from hawkish Fed-speak, the currency won’t be able to fend off further depreciation,” says Shenfeld.

Net-longs remain at a multi-year high even after a partial unwind in early October, which came in response to a series of dovish statements by BoC policymakers that suggested they could wait for some time before hiking rates again.

“Past rate hikes, new mortgage rules and Ontario’s minimum wage increases have all raised the bar for near-term monetary tightening,” Shenfeld adds.

Governor Poloz might use Wednesday’s monetary policy statement to signal a pause is in order for the Bank of Canada, which could prompt a partial unwinding of the market’s large net-long Canadian Dollar position, according to Shenfeld.

“As a result, the dollar-Canada is likely to reach 1.27 by year-end and average 1.29 in 2018,” forecasts Shenfeld. “Things could, however, turn out worse for the currency should NAFTA trade talks fall apart.”

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NAFTA Risk Could Soon Fade But Dollar To Weaken Regardless

Risks to the Canadian economy stemming from a breakup of the NAFTA partnership have probably been overhyped and, according to one strategist, will soon fade from view. However, this may not be enough to prevent the Loonie from succumbing to further weakness.

“NAFTA concerns may also explain the recent, though more modest, reopening of a CAD discount against short-term fair value,” says Daniel Hui, a strategist at JPMorgan.

A fourth round of talks between Canada, the US and Mexico concluded last week with an agreement to continue discussions into the new year, at a slower pace, when they were initially scheduled to conclude by the end of 2017.

“The key question for FX risk managers is whether the trade disruption risks are acute or not,” says Hui. “If we are correct in our assessment that underlying risks from US trade protectionism has not materially changed from earlier this year, then it is only the perceived acuteness of that threat that had faded earlier this year and has (temporarily) reemerged over the past week.”

A mutually acceptable agreement between NAFTA’s three participants, on how to reform the trade pact, has remained elusive so far despite several months of discussions.

“The lesson learned from currencies like MXN and CAD, is that if not a well defined and acute risk, then month-to-month or even quarter-to-quarter performance will still depend on the other conventional macro drivers,” says Hui.

Hui forecasts that NAFTA will gradually fade from view as a driver of price action for the Canadian Dollar, US Dollar and Mexican Peso over the coming months.

There is consensus that the overall effect of a NAFTA breakup on the Canadian economy would be quite small, but not everybody is in agreement on the benignity of the risks posed to the Canadian Dollar.

“While we estimate that the direct impact from a loss of free trade would see a manageable 5% depreciation in the currency, losing the all-important dispute resolution mechanism could see the loonie react more sharply if the US then targets various Canadian sectors with punitive duties,” says Shenfeld at CIBC.

Some see the Canadian economy’s resilience coming from the Dollar and the Bank of Canada acting as shock absorbers in such a scenario - as well as while the economy slows over the coming months.

“Even if NAFTA talks turn out constructive, the recent widening in Canada’s trade deficit and general malaise in non-energy exports, suggest that the economy needs a weak exchange rate to get that sector going again,” says Shenfeld.