Morgan Stanley counsels shorting the Canadian dollar as a hedge against a global slowdown in a research note.

“The disappointing U.S. May labor report, following Fed Chairman Bernanke’s warning, may mark a point of inflection (not necessarily a turning point) for the U.S. economy. The question now is whether the U.S. will decelerate towards trend, as Chairman Bernanke thinks is likely, or below trend,” it says. “If U.S. growth decelerates sharper than we expect, the global economic recovery will be undermined and commodity prices will be vulnerable to sharp corrections. In this risk scenario, we believe that short Canadian dollar against the euro, the Swiss franc and the U.S. dollar (in descending order or preference) are sensible hedges.”

It notes that the loonie has become more of an energy currency in recent years. “Further, the current spot rate of the Canadian dollar has exceeded that which can be explained by these already frothy commodity prices and other fundamentals. In other words, the Canadian dollar is over-valued even at the current elevated commodity prices. In a scenario where global growth falters, commodities will be vulnerable and an over-valued Canadian dollar looks particularly risky,” it says.

The report says that the U.S. will likely continue to lead the global economy. “The rest of the world can continue to recover only if the U.S. does not slow significantly, in our view,” it notes. “In the unlikely event that U.S. growth actually decelerates below trend — not our central case but a scenario many investors have begun to contemplate, at the extreme end of the ‘fear mode’ — the U.S. dollar could stage a surprise rally, particularly against the emerging market currencies and commodity currencies, such as the Canadian dollar.”

The report argues that the Canadian dollar is already over-valued. It adds that if the risk to commodity prices (both energy and non-energy) is biased to the downside, shorting the loonie is a sensible trade. Also, it says, the yield differential between the U.S. and Canada could start to put some pressure on the loonie. “The Bank of Canada stopped its tightening campaign while the Fed is still contemplating the possibility of increasing rates. This could increase the yield differential between the two countries, which is already 75 basis points,” it says.

And, it suggests that the productivity gap between both countries must narrow to sustain current exchange rates, “which is unlikely to happen soon.

“We may have seen an inflection, rather than a turning, point on U.S. growth. Depending on the extent of the deceleration in U.S. growth, global growth will be affected,” it concludes. “A gentle slowdown in the U.S. that still permits the rest of the world to recover is perhaps the most U.S. dollar-negative scenario, as a sharp collapse in U.S. demand could trigger a safe haven run into U.S. dollar assets. In a global slowdown scenario, we believe that the Canadian dollar will be vulnerable against euro, Swiss franc and U.S. dollar.”