Notwithstanding its recent strength against the U.S. dollar, UBS Wealth Management Research still likes the Canadian dollar over the next couple of years.

In a new report, UBS says that it is maintaining its positive view on the Canadian dollar “as we have identified several factors that are likely to support the currency”. These include strong economic data, rising oil prices, improving risk sentiment, and the possibility that other central banks could decide to add the Canadian dollar to their currency reserves.

“The increasing likelihood that the [Bank of Canada] might soon adjust its conditional commitment to keep rates at a record low level until the end of the second quarter and start to gradually increase the policy rates, makes the [Canadian dollar], in our view, an attractive investment currency,” it says. “We expect the first rate hike of 25 [basis points] to take place in July, well ahead of the U.S. Federal Reserve, which we do not expect to hike before September.”

Additionally, it suggests that improvements in general risk sentiment could also help the risk-sensitive currency. “The loonie tends to be supported by risk-taking and has suffered as markets unwound risk. This leads us to expect the loonie to gradually strengthen further against the USD, as, in our view, a further improvement in risk sentiment is likely,” it says. It cautions, however, that tightening by Asian central banks in the next few months could temporarily weigh on risk sentiment.

Rising commodity prices could also serve as a support for the loonie. “Looking at the high correlation of the CAD to the oil price and our above-consensus commodity forecasts, expecting a rise above $90/bbl in second-quarter 2010 and remaining at that level for longer, we believe that there is still upside potential for the CAD,” it adds.

Finally, UBS suggests that other central banks could use the Canadian dollar as a reserve currency. It notes that central banks hold 98% of their reserves in the four major currencies, the U.S. dollar, Euro, Yen, and British Pound.

“The Russian central bank has already signaled its intention to add the [Canadian dollar] to its currency reserves,” UBS notes. “The Canadian bond market is quite deep and provides better liquidity than the bond markets of most other commodity and emerging market countries. The CAD’s role in the reserve diversification dynamic over the next few years is, in our view, another potential support factor for the currency.”

UBS points out that the loonie has already appreciated by about 20% against the U.S. dollar over the last 12 months and is slightly overvalued, according to its purchasing power parity calculations.

“Nevertheless, in our view, the CAD still has potential to appreciate owing to the relative growth outlook,” it says. “However, we have to point out that many other investors share this view and that the first-mover advantage has already passed. As a result, should Canada not meet investors’ high expectations, then the CAD might suffer.”