(Bloomberg) – Forex traders are feeling a little nervous about Canada.

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As voters deliver their verdict on Prime Minister Justin Trudeau’s government at the polls on Monday, the market takes a starkly negative view of the local currency, despite recent strength in resource prices. Indeed, rising global commodity costs could even become a headwind for the country’s economy rather than a tailwind, as concerns about domestic inflation take center stage for citizens, politicians. and central bankers.

The loonie, as it’s affectionately known for the bird that adorns Canada’s coins, was one of the worst performing currencies in developed markets during the second half of this year. After overtaking all of its Group of 10 counterparts in the first six months of 2021, it has fallen 3.2% since June 30. And activity in derivatives markets suggests there could be more pain ahead for the currency even as the Bank of Canada begins to lead the way for a tightening of monetary policy.

“It has become fairly clear over the past two weeks that the Canadian dollar is just not responding to some of the positive fundamental impulses in the way we expected,” said Shaun Osborne, chief currency strategist at the Bank. Scotia. “I suspect the CAD may continue to struggle a bit.”

On Monday, the loonie was the second worst-performing G-10 currency amid a vast stocks and commodities rout, as investors weighed the impact of China’s struggling real estate sector.

In the options market, the right to sell the Canadian dollar against the greenback in three months has increased in cost relative to the price of the call rights. So-called risk reversals, which compare the costs of these puts and calls, reached unprecedented levels this month since June 2020, suggesting increased interest in hedging against losses in Canadian dollars.

CME Group data shows traders have built a notional portfolio of over $ 50 billion Canadian dollar low delta put options at strike prices of C $ 1.33 per greenback, another A sign of concern that the loonie has weakened from current levels of close to C $ 1.28. One- and three-month implied volatility measures, meanwhile, have risen in recent weeks, suggesting some investors are bracing for an increase in activity.

Positioning data from the Commodity Futures Trading Commission also shows a decline in the uptrend of the Canadian dollar. While speculators maintain a net long position, this has fallen significantly from its recent high in mid-July, while asset managers are also holding smaller bullish positions than a few months ago.

All of this comes even as the Bloomberg Commodity Index has risen 1.6% since June 30, although crude oil is down about 3.6%.

Opinion polls in Canada have indicated that Trudeau’s Liberals are in an uphill struggle to stay in power, despite promises to increase spending. While the election has generally not been a major source of concern for investors when it comes to Canada, there are a number of elements in this year’s battle between Trudeau and conservative challenger Erin O’Toole. that could potentially influence the markets.

The greatest risk, according to Toronto-Dominion Bank analyst Mark McCormick, will be if a minority government is formed and is unable to move policy decisions forward, which could trigger another election in the not-so-distant future. This could lead to high volatility in the short term, he said.

Trudeau favored a slimmer-than-expected victory in the snap election

Another major potential impact concerns the monetary policy context. The central bank’s five-year inflation-targeting mandate is due to be renewed this year and it is possible that Bank of Canada Governor Tiff Macklem will ask for more flexibility, so whoever is in power could hold the key.

Inflation target

O’Toole said he was in favor of the 2% inflation target as ordinary people struggle to make ends meet. Trudeau said families, not monetary policy, would be his government’s top economic priority and that he wanted to continue with increased stimulus.

New data released on Wednesday showed that year-on-year consumer price inflation accelerated to 4.1% in August, the fastest inflation since 2003 and the fifth consecutive reading above the 3-high cap. % of the Bank of Canada. This accelerating inflation landscape will, of course, be critical for monetary policy: the boss of the BOC said earlier this month that he intends to reduce bond purchases as as the economy recovers, leaving open the possibility of higher rates if consumer costs continue to rise. But it will also potentially have an effect on the election outcome itself, the types of fiscal policy that will emerge in its wake, and the eventual decision surrounding the BOC’s tenure.

“Election results can have an impact on fiscal policy which spills over into monetary policy or vice versa,” said Tom Nakamura, portfolio manager at AGF Management. “There is some concern about the elections. “

Above all this hovers the specter of the US monetary policy decision on Wednesday. Any notable signal from the Federal Reserve regarding its potential timeline for gradual reduction in asset purchases or rising interest rates is likely to have a significant impact on risk assets around the world, including the Canadian dollar and the complex of raw materials.

“It is clear that the Fed will begin the process of reduction this year and at the same time we have reached the peak of BOC hawkishness,” McCormick said. “The main driver of the loonie now is the outlook for the dollar and global risk sentiment. “

(Updates with the loonie’s performance in the third paragraph and prices throughout.)

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