By Julie Haviv
NEW YORK, July 16 (Reuters) - The Bank of Canada is widely expected to hold interest rates steady this week, but with an increase expected in less than a year, investors in the options market have become less bullish on the U.S. dollar's upside versus the Canadian currency.
Options investors are still betting on the U.S. dollar strengthening against the Canadian dollar, but they have been paring those bullish positions in the past few weeks.
Dismal U.S. data has raised expectations the U.S. Federal Reserve will launch another round of bond buying, called quantitative easing, to boost a slowing economy while interest rates should remain near zero until at least late 2014.
While the BofC is expected to keep interest rates unchanged at its meeting Tuesday, a rate hike is expected in the second quarter of 2013, a Reuters poll showed.
"The options market is positioning for a move lower in the U.S. dollar versus the Canadian dollar," said Camilla Sutton, chief currency strategist at Scotiabank in Toronto.
Risk reversals, a gauge of currency market sentiment, show the positive outlook on the U.S. dollar has waned somewhat.
Three-month U.S. dollar/Canadian dollar risk reversals show a solid bias for calls for the U.S. currency, or the right to buy the greenback, trading around 1.5 percent on Monday, but that is down sharply from 3.2 percent in early June
That is around where they traded in late April and early May, when the currency pair traded below parity.
There are several reasons why the U.S. dollar should move lower after the Bank of Canada meeting passes, Sutton said. These include Canada's triple-A rating, "a still relatively hawkish Canadian central bank, relatively strong fundamental data," and diversification from Europe.
The U.S. dollar, last at C$1.0142, is down 0.5 percent against the Canadian dollar in 2012. Since the Bank of Canada's June 5 meeting the Canadian currency has rallied about 2 percent
George Davis, chief technical analyst at RBC Capital Markets in Toronto, said the move in dollar call bias over the past few weeks is mainly due to the fact that the currency pair failed to take out resistance at C$1.0410 and trade materially higher.
The pullback from the high on June 4 to the current level caused the "erosion in the bullish dollar view," he said. "Hence, people have been taking those risk reversal trades off given the lack of topside follow-through."
The change in U.S. dollar/Canadian dollar call bias can also be seen in long-term risk reversals, widely used by banks for hedging activity. One-year risk reversals <C A D1Y RR=GFI> we re trading at 2.3 percent, down from 3.8 percent in early June.
U.S. dollar/Canadian dollar risk reversals indicate volatility in call options exceeds volatility in put options, with more people betting on greenback gains, but the fall over the past month indicates fewer people are betting on an increase in the U.S. dollar.
"The futures market continues to look at a tightening bias by the Bank of Canada in early 2013," said Dean Popplewell, chief currency strategist at OANDA in Toronto.
"Canadian long-term interest rates exceed their U.S. counterparts by the largest spread in nine months, which is influencing demand for the loonie," he said.
"The Canadian dollar is preferred on dollar rallies for reserve and second-tier risk reserve requirements and the fear that the Fed may mention QE3 over the next few days."
U.S. Fed Chairman Ben Bernanke will deliver his semi-annual testimony on monetary policy before Congress on Tuesday and Wednesday, with markets monitoring for any indication of a shift in favor of a third round of quantitative easing.