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One of Canada's biggest banks believes a bout of Canadian Dollar strength looms and all that is required to trigger it would be a stabilisation in global equity markets.

BMO Capital Markets, the investment bank division of Bank of Montreal, says the USD/CAD exchange rate is "likely to make a hard turn lower" as it is due to unravel overbought conditions.

Greg Anderson, Global Head of FX Strategy at BMO Capital Markets, says the potential driver to a rally in the Canadian Dollar could well be developments in equity markets and he is watching the bellwether S&P 500 in particular.

"We think the next several big figures in USDCAD are likely to depend on what the S&P 500 does," says Anderson.

Above: CAD/USD (top) and S&P 500, showing an increasingly positive correlation.

BMO Capital modelling shows the S&P 500 is now the most important factor in determining USD/CAD dynamics, replacing the three-month interest rate differential.

"If the equity panic reasserts itself over the next couple of weeks, then we could see USDCAD making another push through 1.3050 and potentially 1.3150," says Anderson.

Indeed, if the S&P 500 were to drop to 25% year-to-date, BMO Capital wouldn't entirely rule out a move in USDCAD to 1.3350 as Canadian pension managers trim their short-USD/CAD hedges due to having less assets to hedge.

But it could take a relatively small move higher in stock markets to trigger an outsized move in the Canadian Dollar which is looking overextended.

BMO's research finds the recent move lower in the Canadian Dollar is already quite extended at levels above $1.28 as WTI crude oil prices remain above $100/barrel.

In addition the exchange rate is found to be overextended relative to where Canada's and the U.S.'s external balances are at.

They say it is also overextended relative to where the two countries are at with post-pandemic fiscal consolidation and above $1.28 the exchange rate can be considered overextended to where expectations of relative monetary policy are at in the wake of last week's FOMC.

"We are of the belief that USDCAD will make a fairly quick move back down to 1.28 whenever the global equity market stops panicking," says Anderson.

The outlook for the Canadian Dollar therefore rests with the ability of stock markets to stabilise, of which there are decent prospects.

"In our view, the equity market has fallen so far and so fast because it was hit by 3 shocks: rapid Fed tightening, the Ukraine War, and a pandemic wave in China. The first of those factors is getting better, while the second isn't getting worse. The third may well be the crux of things, both for the S&P 500 as well as USDCAD," says Anderson.

He acknowledges timing this will be difficult, but "when the equity market learns to live with that factor and bounces a bit, we think USDCAD will make a hard turn lower".