European Central Bank QE and the U.S. Dollar

Jason Ayres
May 20, 2014
5 minutes read

Last Thursday Mario Draghi confirmed the suspicions of many…that the European Central Bank was preparing a Quantitative Easing type policy package for its next meeting scheduled for June. Considerations will include cuts in interest rates and other measures with a focus on stimulating lending to small and medium size business.

It should be noted that the European Central Bank (ECB) has yet to suggest a “money printing” program that would be comparable to the U.S. Fed solution to introducing stimulus to the economy. Regardless, the impact on the Euro based on their statement of intentions was swift. The Euro began selling off and continues to show signs of weakness.

Since currency is based on a FIAT system where one currency is only worth it’s value comparable to another currency, we have subsequently seen the U.S. Dollar jump on the news.

So the question is whether we are now about to see a “tipping of the scales” between the U.S. Dollar and the Euro? If we believe in the “currency Wars” theory ( an interesting read by James Rickards) which suggests that countries are competing to devalue their currency in a bid to stimulate foreign investment, and increase manufacturing for foreign export… then it makes sense. This has been the mandate of the U.S. for the last several years. With it looking as though they are slowing down their “easing” it makes sense that we see a swing towards the Euros devaluation.

We can’t necessarily assume that this move by the ECB will facilitate a move higher in the U.S. Dollar and it’s relationship to the Canadian Dollar. However, it is in Canada’s best interest economically for the Loonie to remain cheaper than the U.S. Dollar. With Canadian interest rates likely to remain low for years to come according to Bank of Canada’s Stephen Poloz, there isn’t likely to be anything to stop the U.S. Dollar from continuing to appreciate against the Canadian Dollar.

If you have an expectation for the U.S. Dollar to continue its uptrend against the Canadian Dollar you could participate by purchasing USX call options.

USX options are priced based on the U.S. Dollar relationship to the Canadian Dollar. 1 contract provides exposure to US$10,000.00. The purchaser of a USX call option has the potential to profit if the U.S. Dollar increases in value against the Canadian Dollar with in the time frame selected. The final settlement is based on the difference between the strike price selected and the Bank of Canada noon rate on the expiration date. If the call is in-the-money, the option will be settled in Canadian Dollars otherwise, it will expire worthless.

To understand the strike prices as they relate to the actual spot market you multiply the spot market rate by 100. For example, with the spot market rate currently sitting at 1.0893, an at-the-money USX call strike would be 109. for more information on USX options you can watch this video Introduction to Currency Options or download the .PDF file.

Regardless of my assumptions, I always want my technical observations on the price chart to confirm my fundamental expectations. With that in mind, we can take a look at the daily chart of the USD/CAD and make a few observations as well as set some “rules” in place to identify a when it might be time to take action.

1. Potential Declining Wedge forming indicating a pause in the prevailing uptrend for the USD. This formation is known as a continuation pattern indicating that the USD has a high probability of moving higher
2. A close above the cluster of moving averages (8,21,62) at approximately 109 confirms a that USD/CAD shorter term prices are beginning to trend higher than the longer term average
3. Stochastics Oscilator indicates overbought/oversold conditions. The chart below show stochastics oversold and building momentum for a move higher

USD/CAD Daily – May 20, 2014

If you are confident in a continuation higher in the U.S. Dollar against the Canadian Dollar, a September, 109 call option could be purchased for approximately 1.36 or $136.00 per contract. This would put your break even point at a spot market exchange rate of 1.1036 on expiration. Keep in mind that you can close the position at any time to lock in profits or cut losses.

Jason Ayres
Jason Ayres http://www.croftgroup.com/

CEO and Director of Business Development

R.N. Croft Financial Group

Jason is CEO and Director of Business Development at R N Croft Financial Group, a member of the Croft Investment Review Committee and a Derivative Market Specialist by designation. In addition, he is an educational consultant for Learn-To-Trade.com and an instructor for the TMX Montreal Exchange.

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