Canada and Australia Update

Fitch left the ratings and outlooks of Canadian banks unchanged earlier today, while placing Australia's four largest banks on negative credit watch. The main reason for warning on Australia but not Canada is that Australian banks are more reliant on foreign wholesale funding.

Canadian banks also have a lower loan/deposit ratio and a relatively higher deposits to funding than Australian banks. On the other hand, Australian banks have higher interest margin and return on assets than Canadian banks.

Banking sectors in both countries are highly concentrated. The top four banks in Australia account for about three quarters of the banking assets. The top six Canadian banks account for upwards of 90% of the Canadian banking assets. According to Fitch, the concentration and high profits of the banking sector is favorable to each as it provides a cushion against losses and need to pursue higher risk activity/lending.

Both Canada and Australia are experiencing over-valued housing markets. The IMF estimates Canadian house prices are about 10% risk while Australia is 10-15% over-valued.

Separately, Canada's bank regulator warned that Canadian banks are loosening mortgage lending standard. According to a report that Bloomberg accessed under the freedom of information law.

Bank of Canada Governor Carney has warned that the indebtedness of the household sector in Canada is the greatest domestic threat to Canadian financial institutions. Stats Canada reports that in Q3, household debt reached a record 153% of disposable income. US households may be de-leveraging, but it looks like Canadian households are not.

We note that as US money market funds have reduced exposure to European bank paper, they have turned to both Canadian and Australian bank paper (and UK and Scandi paper). Several central banks appear to be diversifying reserves in recent quarters into Canadian and Australian dollars.

Meanwhile, the Canadian 2-10 yield curve has flattened to levels not seen in more than 3-years at less than 100 bp. In contrast, the Australian curve has steepened as the RBA rates cuts (two thus far and the next expected Feb 7) has pushed the 2 year down much faster than the 10-year yield has come off. The Canadian 2-year in anchored by expectations that Bank of Canada will continue to be on hold as it has been since Sept 09.

With the Fed pushing out the likely time frame of their first hike, the BoC will continue to be in no hurry to raise rates.

The US dollar slipped in the second half of last week to flirt with parity against the Canadian dollar but failed to close below CAD1.00. Since mid Jan, the US dollar has dropped about 3% against the Canadian dollar. As of a week ago, the latest CFTC data shows the next speculative position at the IMM had a larger net short Canadian dollar futures position than seen over the past few years, with the notable exception being the end of 2011.

While the Canadian dollar can out perform against the major European currencies in a firm US dollar environment, the Canadian dollar appears vulnerable to a near term set back against its US counterpart. A number of technical indicators warn the upside momentum in the Canadian dollar has begun flagging. Initially there is scope for a 1% bounce in the US dollar toward CAD1.0135. A move above there could see a correction toward CAD1.0250-80.

Given Fitch's announcement earlier today, many will look at the CAD-AUD cross. The Australian dollar appears to be running out of steam against the Canadian dollar. There is speculation in some quarters that the RBA could deliver a 50 bp cut next week (we stick to a 25 bp move) and that might add to some of the Aussie's weakness. The Australian dollar finished last week just below CAD1.07, the strongest level against the Canadian dollar since 1997. While it may be tempting to pick a top, a break of the CAD1.0550 area may be needed to raise confidence a top is in place.