How would you like an 860% return to close out the year?
About this time last year, October 2017, we were discussing what turned out to be a massive boom and bust cycle in the crypto markets. While Bitcoin appreciated 250% in just three months, other crypto currencies did far better. If you were an active trader like me, it was the perfect market to make a killing. This year, while the crypto market lies dormant, another monster trade is just getting started — and it’s already up 26% month-to-date.
As a Detroiter, crossing the bridge or tunnel into Canada was a rite of passage into adulthood. Windsor, the town just across the river, offered a raging party powered by their comparably low legal drinking age of just 19 years. Once across the border, we went straight for the nearest ATM to get our hands on some colorful loonies, our drink tickets for the night. What happened after that, well, what happens in Canada, stays in Canada.
At the time of our Canadian escapades, from around 1997 through 2000, the loonie gained on the US dollar, trading from around $1.20 to 97 cents. (The dollar-CAD or loonie rate can be read as one US dollar buys [the rate] Canadian.) For a bunch of college kids, when we ran out of loonies, we readily offered our US dollars and the bars where happy to accept them on a 1:1 basis, pocketing the exchange rate spread. Today, the rate stands at $1.31 and I expect the pair the trade to $1.55 in the coming months, 18% higher (for the USD) than it stands today. Before we get to how I arrived at my forecast, let’s first dive into how a 18% gain can translate to 860%.
The Power of Leverage
Perhaps you’ve traded on margin in your stock account or maybe you charged some crypto to your card through Coinbase last October. If you’ve done either, you engaged in leverage, using borrowed funds to enhance your gains (or losses) in your trading. Trading on margin in your stock account or funding your trading with a credit card generally results in a 2:1 leverage ratio.
Trading with futures, options or spot FOREX is different. These markets offer 40 to as much as 400:1 leverage, with 100:1 being the most common for futures and options. With that said, leverage is a double-edged sword. While you can juice your gains, you can also lose some or even all of your money, potentially very quickly, if you’re not careful. However, for traders who carefully manage and measure risk on every trade, the opportunity for profit is immense. If you don’t have anyone who can help you, I might be able to point you in the right direction.
Fundamental Analysis: Trump’s Tariffs & USMCA
In case you’ve been asleep since 2016, reality TV star and real estate mogul, Donald Trump, is now the President of the United States. True to form, he has stayed with the controversial style that gave rise to his fame. As President, he seems to have stepped up his controversy game, pursuing and implementing policies that have riled his opposition and emboldened his base. To his credit, he has passed a landmark tax bill and replaced NAFTA with USMCA, the US-Mexico-Canada Agreement.
The passage of the Tax Cuts and Jobs Act of 2017 added extra fuel to an economy that was growing steadily. The addition of the United States-Mexico-Canada Agreement makes for a potent inflation-inducing cocktail that gives the Federal Reserve the ammunition it needs to raise rates.
USMCA specifics are as follows:
· Takes effect in 2020
· Steel (25%) & aluminum (10%) tariffs remain
· 70% of steel and aluminum must originate from within USMCA region
· Regional content for cars and trucks increases from 62.5% to 75%
· $16/hour average employee earnings for 30% of production
· $16/hour requirement increases to 40% by 2023, just three years after implementation
While the USMCA takes effect in 2020, steel and aluminum tariffs are already in place. They went into effect in June 2018. With that said, let’s explore why I expect this fiscal package to drive divergence between the US and Canadian currencies.
7% of Canadian Economy Affected
Canada exports 90% of their steel and aluminum production to the United States, according to the Canadian Steel and Aluminum associations. This accounts for 20% of U.S. total steel imports and 50% of aluminum imports, by far our largest supplier, equaling $11.5 billion in 2017. The Canadian steel industry employs 22,000 people in Ontario while another 8,300 people are employed for aluminum production in Quebec — and that’s only direct employment. Canadian steel and aluminum goes into cars, refrigerators, and even beer, among many other products, all of which now have higher prices when sold to their primary customer across the border.
A closer look into Canadian exports shows just how big this problem is: the affected export markets that include steel and aluminum account for 30.2% of Canada’s total export market — $127.2 billion of the $420.6 billion in total exports in 2017. Considering that 75% of Canadian exports are bound for the U.S. and exports account for 31.4% of Canadian GDP, that approximates to 7.1% of the Canadian economy. To put that in human terms, approximately 1.2 million of the 16.6 million working Canadians are affected by the tariffs.
· Cars & Trucks: $62.3 billion (14.8%)
· Machinery: $32.4 billion (7.7%)
· Electrical machinery & equipment: $13 billion (3.1%)
· Aluminum: $9.8 billion (2.3%)
· Aircraft, spacecraft: $9.7 billion (2.3%)
Now, if you’re running the Canadian economy and 1.2 million people may suffer due to a renegotiated trade deal with your largest trading partner — that you approved — would you take it on the chin or would you do something about it?
Businesses in a Bind
When the market suddenly shifts, and your product becomes 10–25% more expensive, you have two choices: adjust your cost structure in order to retain your market share or sell less product. Since the second option is essentially an admission of defeat and would result in layoffs, lower stock prices, and a likely change in Parliamentary control, the first option: adjusting your cost structure, absent government assistance, is the only alternative. With that said, let’s explore the cost structure and available options.
The cost to produce goods that include Canadian steel and aluminum has not changed. Therefore producers must choose between cutting labor costs, improving productivity, or slashing their profit margin to offset for the added cost at the border. Again, this applies to all Canadian companies producing export goods containing steel and aluminum that are destined for the U.S., not just the manufacturers of the raw product.
Economic indicators suggest that businesses are attempting to adjust, but their adjustments may fall short of the required price adjustments for their particular company and industry. Statistics Canada reports that average hourly Canadian manufacturing wages decreased by 2.2% from June to July of this year, from $25.47 to $24.90 per hour, a clear response to the unanticipated tariffs. Adjustments to labor productivity can be made too, by employing fewer people to work longer hours. Investing in new equipment to enhance productivity is also effective, but over a 12 month or longer time frame for implementation. Like hourly earnings, productivity improvements are also reflected in the data: Canadian producer prices have declined from the June peak of 108.49 to 107.76 as of the August PPI report, perhaps an indicator of modest productivity improvement. Finally, the businesses could opt to lower their profit margin, which could result in lower share prices across a broad swath of publicly traded Canadian companies.
None of these options will be popular with the voting public, the affected hourly employees or the business owners and investors who finance political campaigns.
Trudeau to the Rescue
Prime Minister Justin Trudeau may have been forced to agree to the tariffs, but he is not without options. As we discussed, he could do nothing and have his people and businesses suffer, or he could make the entire economy more competitive. While the Bank of Canada manages the economy and not Trudeau, I would be shocked if the BOC didn’t take the effect of Trump’s tariffs into consideration when determining interest rates. If the BOC chooses to maintain rates rather than raising rates on Wednesday, as expected, the loonie will drop like a duck in Duck Hunt.
Whereas businesses and their employees suffer in the scenario that does not involve government action, devaluing the Canadian dollar vis-à-vis the US dollar provides immediate relief across the board. USMCA requires that 30% of manufacturing content be produced by employees earning an average of $16 per hour — in US dollars. That’s an important distinction because it means that Canadian and Mexican manufacturers need to consider the exchange rate adjusted wage paid to their employees.
The USD.CAD exchange rate as of today, October 23, 2018 is $1.31. The average Canadian manufacturing employee earns CA$24.90, translating to US$19.00. If Canada wanted to reduce average hourly earnings to the US$16 per hour USMCA threshold, that would require an exchange rate of $1.5562, a 18.8% slide against the US dollar. Of course, Canada could devalue further without penalty provided that employers raised wages enough to offset a lower exchange rate.
(In case you want to see the math: CA$24.90 / $1.31 = US$19.00; CA$24.90 / US$16 = $1.5562)
With that said, Canada could also strategically opt to let the loonie fall even further, spurring wage gains in the process. The USMCA requires that automobiles must be produced at plants that conform to the US$16 wage or be subject to additional duties. In other words, if the loonie slips beyond $1.55, manufacturers would be forced to boost wages to comply. To me, that sounds like a recipe for an election year victory.
The Bottom Line
Prime Minister Trudeau and his parliamentarians are up for re-election in April of 2019, just six months from now. Suffering a political defeat at the hands of a strongman president south of the border and an economic defeat that will affect millions of voters is a surefire way to lose a re-election campaign. Unless the Bank of Canada wants Trudeau to lose, and I don’t think that’s the case, they’ll opt for immediate relief through a lower loonie and hourly pay raises instead of cuts. I can think of no better way to go into an election season.
To that end, I believe the BOC will either maintain rates rather than raising on Wednesday, as is broadly expected, issue a dovish outlook on interest rates, or both. Additionally, I expect the USD.CAD exchange rate to reach $1.55 no later than the April elections, perhaps sooner. Further devaluation will depend on how fast the Bank of Canada wants to stimulate wage gains across the manufacturing sector. And by the way, a $10,000 investment levered at 40:1 over the term of adjustment could yield a gain of $86,000 — an 860% return.
Joe McHugh is a Commodity Trading Advisor specializing in FOREX and crypto, and he is currently accepting new clients. You can message him on Twitter (@joemchugh) and LinkedIn. Disclosure: This is not a recommendation to buy or sell any currency. Consult your advisor before making investment decisions.