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Is the Loonie Really Set to Fly South?

Monday - 6/17/2013, 2:49pm  ET

O' Canada!

The consensus has turned against the the Great White North as the number of hedge funds betting against the country continues to grow. But the trade is getting crowded and recent economic data should cause the bears to reconsider their thesis.

The great white short

The bear thesis against Canada is pretty simple.

  1. Slowing growth in emerging markets will put a drag on commodity prices 
  2. The over-indebted Canadian consumer is finally tapped out 
  3. Frothy real estate prices are due for a correction

And there are lots of big names betting against the Loonie and by proxy the CurrencyShares Canadian Dollar Trust ETF 

Vijai Mohan, founder and portfolio manager at Hyphen Fund Management, recently announced he's all-in against Canada betting 95% of his portfolio against the Canadian dollar and the nation's banks. 

Marc Faber, editor of The Gloom, Boom and Doom Report predicts that Canadian real estate is in bubble territory while household debt is too high

Steven Eisman, famous for betting against the U.S. housing market, has issued similar warnings against the Canadian real estate market

The problem with so many high profile names betting against Canada, the trade is starting to look crowded. 

According to the U.S. Commodity Futures Trading Commission, bearish bets against the Canadian dollar exceeded 76,000 contracts in April making the loonie the most shorted currency behind the Japanese Yen. 

The last time short interest was this high against the Canadian dollar was in July 2007. The result - a massive short squeeze that sent the loonie up 7% over the next three months. 

With so many speculators betting against the country, problems have likely already been priced in so that the market could be due for an upside surprise. 

Holes in the bear thesis

In addition, the recent economic data is starting to poke holes in the bear thesis. 

Two weeks ago, Statistics Canada reported 95,000 jobs were created in May. This was the best number in 37 years and reduced the unemployment rate to 7.1%. 

No apparent signs of a slow down in real estate. Last week, the Canadian Mortgage and Housing Corporation reported 200,000 housing starts in May, up from 176,000 in April. This blew past analysts expectations in spite of tighter lending rules passed by the Federal government. 

Both of these economic reports suggest economic growth is picking up after a soft 2012 and a Bank of Canada interest rate hike could be back on the table. That would be a catalyst for a higher loonie. 

Canada's equity markets also look attractive. 

The iShares MSCI Canada Index  remains 16% below its 2008 peak. The index has under-performed the S&P 500 by 15% over the past year.

Most of this decline can be credited to weak commodity stocks which make up half of the index. Materials and energy stocks are down 45% and 22% respectively since 2011. 

But a few catalysts could send those shares higher. 

First, the discount for Canadian crude is shrinking. The spread between Western Canadian Select and West Texas Intermediate hit a record $40 per barrel last winter. However, that discount narrowed to $17 per barrel this spring as railroads and pipelines begin to clear clogs in the energy supply chain. 

Second, despite record short interest, Canadian banks reported strong earnings this quarter. Take Royal Bank , the nation's largest financial institution, as an example. Last month the company announced a $1.9 billion second quarter profit up 26% driven by strong gains in trading and wealth management. Even the company's supposedly troubled retail arm posted a impressive 12% earnings gain. After hearing for years the Canadian banks are due for a slow down, all of the negatively is looking misplaced.

Foolish bottom line

The Canadian dollar is pricing in a major recession. But a strong jobs report, solid housing numbers, and stronger commodity prices should cause the bears to revisit their short thesis. 

This article was originally published as Is the Loonie Really Set to Fly South?on Fool.com

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