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USD/CAD Q4 Outlook

Friday, 13 October 2006 20:52:36 GMT  |  DailyFX Research Team

The US - Canadian dollar currency pair traded within a relatively tight range throughout the third quarter fluctuating between a high of 1.1460 and a low of 1.10958. (Clicl to See Full Story)

USD/CAD Outlook

The US - Canadian dollar currency pair traded within a relatively tight range throughout the third quarter fluctuating between a high of 1.1460 and a low of 1.10958.  Oil prices have fallen significantly over the month of September and the Canadian dollar is finally beginning to react.  Whether we see further losses in the Canadian dollar will depend on a number of key factors in the domestic and global economy.  Namely, can the country sustain current levels of growth despite a currency near 18-year highs?

Commodities continue to dominate Canadian Dollar action

Any serious FX trader should know that commodity prices play a large role in the valuation of the Canadian dollar. In real number terms, crude oil and related energy products account for over 20 percent of all exports, or nearly 10 percent of the Canadian economy as a whole. Though oil is technically traded in US dollars, repatriations of funds comprise a very significant portion of Canadian dollar demand. Clearly, higher oil prices favor the domestic currency, thus the question remains: where will oil prices head through the final quarter of 2006?

After reaching all-time highs of $78.40 per barrel through August, the price of crude oil dropped 25 percent to below $60 in early October. A progressive easing of geopolitical tensions and slowing global demand have driven prices lower, causing concern among oil-producing countries. The swift drop prompted several OPEC members to call for production cuts that would serve to limit further declines in the price of crude oil. Though the cartel’s participating countries have already been producing below their respective quotas, a large drop in output could certainly limit further declines in the commodity. Questions remain, however, on whether these proposed output reductions will be enough to stem the seasonal decline in the price of oil. The end of the US summer driving season means that gasoline producers limit their purchases of the raw energy source—producing October declines in oil prices through 8 of the past 10 years. This leaves a significant unanswered question in the coming months of Canadian dollar trading: will oil continue its recent slide?

Other Export Markets Continue to Feel the Pinch

Though Canadian export volumes rose significantly on the back of higher commodity prices, an exchange rate at 18-year highs placed considerable pressure on other markets for goods and services. This trend was most easily visible through manufacturing shipments data, which showed annualized declines in six of the first seven months of 2006. As record crude oil prices lifted energy exports to all-time highs, domestic firms found it much more difficult to contend with real exchange rates that made their products significantly more expensive to international consumers. In the end, important trade-driven sectors contributed nothing to headline economic growth. What remains to be seen, however, is whether a pickup in domestic demand will be enough to keep headline expansion above trend in the final quarter of the year.

Canadian Growth: Will Consumption and Land Values Stand up to the Challenge?

Given declines in manufacturing exports, Canadian producers will depend on the domestic consumer to pick up the slack created by their international counterparts. Recent trends in retail trade suggest that this has in fact taken place throughout the first half of the year, with July retail sales data posting 5.7 percent year-on-year growth. A strong labor market plays a pivotal part in the underlying trend, with the most recent results showing that unemployment remains near 32-year lows through September. In fact, the outlook on employment substantively improved on the month, as the sector sharply rebounded following three periods of consecutive declines. Real wages followed suit, gaining 3.0 percent on the year. Bank of Canada watchers were keen to notice the change, as the rising pay rates hint at the possibility of continued inflation.

When will the Bank of Canada cut rates?

Analysts continue to monitor headline CPI growth to gauge the likelihood of central bank interest rate cuts through the end of the year. Initial expectations of such near-term rate changes now seem unfounded, with the economy holding up and synthetic forward rates currently calculating virtually no chance of interest rate changes through the fourth quarter. Regardless, it will be important to watch both headline inflation and real wage growth through the end of the year. Clearly, soft price pressures and/or slow salary growth will increase speculation of interest rate moves in the medium term. Consumer price inflation fell to 2.1 percent in August—a far cry from 12-month highs of 3.4 percent in September, 2005. Sharply lower oil prices have limited inflationary pressures, and have in fact prompted forecasts of 1.0 percent annualized CPI growth in September—substantively below the Bank of Canada’s 2-3 percent inflation target. Such a result would in all likelihood push the Canadian dollar lower against its U.S. counterpart, which already enjoys a 100 basis point interest rate advantage. Of course, with similar expectations of lower US interest rates if the US economy slows, the Canadian dollar may stand to benefit on a narrowing of the overnight lending rate spreads between the two economies. It is important to note, however, that signs of progressively slower U.S. growth may not be necessarily be long term bullish for the Canadian dollar. Given the nation’s dependence on the economic strength of its southern neighbor, the Canadian dollar would likely drop against other foreign currencies if US expansion falls below trend. 

Weaker US Growth Poses a Risk to Canadian Economy

Signs of a slowdown in the US could spell disaster for Canadian industries, which send approximately 85 percent of all exports to the economic giant. Indeed, domestic firms have and will continue to depend on the resilience of the American consumer, who continues to spend despite a soured housing market and subsequently lower disposable income. Numbers show that US imports of Canadian goods make up approximately one-third of Canada’s Gross Domestic Product. As such, any signs of potential declines in American personal consumption could effectively erase prospects for broader Canadian economic expansion. Traders will scrutinize US economic data to gauge the strength of the consumer with Canadian growth in the balance.

Conclusion

The Canadian dollar is still not trading far from its 18-year highs despite sharply lower commodity prices. Indeed, the divergence between the Loonie and oil prices was so pronounced that the correlation was virtually non-existent. Regardless, it seems that traders continue to react to developments in world energy markets as more recent trading will show. Thus it will be critical to monitor the price trends in commodity markets to measure the future of the Canadian dollar exchange rate. It is important to note, however, that continued strength in the domestic currency would actually harm the national economy – as there is always a point that it does for export dependent countries. As recent data has shown, Loonie strength has limited the export growth that accounts for over 40 percent of GDP. While lower energy prices may prove Loonie-bearish in the short-run, such declines would in fact improve the economic outlook for 2007. It is critical to note, however, that such a potential recovery rests squarely on the shoulders of the US economy. If the expansion in the world’s largest economy slows or grows negative, one can be sure that its Canadian counterpart would follow suit. As such, it is important to watch how all of these factors play out so as to forecast direction of the USDCAD currency pair through the final quarter of 2006 and through the beginning of 2007.

Technical Outlook

We focused on the reversal scenario in the last outlook and mentioned that “a break above the trendline would encounter the 7/12 high at 1.1398 as initial resistance”.  Bulls managed to bid USDCAD through the nearly 4 year trendline to 1.1456 on 7/24 but the pair retraced to test the broken trendline as support.  The path has been higher since.  Bolstering the bullish break of the trendline is the push above the 40 week SMA – a weekly close above would be more impressive.  The rally from 1.1028 to 1.1294 and the subsequent decline to 1.1085 may have been the first two waves in a 5 wave bullish sequence.  The ‘personality’ of the rally from 1.1085 fits that of a third wave in that it has been swift.  If this is a 3rd wave rally, then price should exceed 1.1456 and potentially extend to the 161.8% fibo of 1.1028-1.1294 (from 1.1085) without falling below 1.1085.  The 261.8% extension is at 1.1780 – just above the 4/3 high at 1.1771.  Retracements of the 4 year decline from 1.6193 to 1.0927 do not even begin until the 23.6% at 1.2160.  A drop below 1.1085 negates the immediate bullish implications from the trendline break.

USD/CAD Weekly Chart (Source: FXTrek Intellicharts)

USD/CAD Positioning

As the chart below illustrates, speculators have remained long of Canadian Dollars (short USDCAD) for most of the 4 year decline.  The occasional pullback has occurred when traders owned too much of the Loonie.  The trend since the beginning of 2006 has been to liquidate long Canadian Dollar positions and speculators are close to becoming net short of the currency (which corresponds to net long of USDCAD).  The chart below clearly illustrates that when the speculative community has been short of Canadian Dollars, the USDCAD rallies.  In other words, the trend following trading community tends to get the direction correct most of the time.  It is at the extremes when herd mentality has replaced independent thinking that the reversals occur and the crowd is wrong.  

 

 

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