The Canadian dollar has recently rallied to fresh multi-decade heights against the US dollar, with record crude oil costs stoking strong demand for the Canadian currency. With the world’s second-largest proven oil reserves, Canada has undoubtedly benefitted from the commodity’s meteoric uptrend. Given the fact that it is the single-largest exporter of oil to the United States, it is little surprise that the US Dollar-Canadian dollar exchange rate has held a historically high correlation to the price of crude oil. However this correlation is waning, indicating that US dollar weakness is becoming a bigger driver of USD/CAD than just oil prices. Therefore it remains to be seen whether $100 oil will drive USDCAD below 90 cents.
More recently, however, the strength of the correlation between the USDCAD and oil prices has begun to falter. After turning positive through mid-2007, the 50-day rolling correlation actually remains at its weakness since 2005. The conclusions of such results are relatively straightforward: crude oil has certainly played a large part in the broader USDCAD downtrend, but it remains clear that its influence has become less significant as time has worn on. The more recent leg of USDCAD weakness seems to follow recent market tendencies towards US Dollar selling – indicating that oil prices is not the only factor driving the currency pair low. As such, it remains critical to examine any factors that may affect the US dollar.
Oil Just Whiskers below $100, but Can it Drive USDCAD Even Lower? In addition to rising oil costs, falling interest rates have been a key contributor to recent USDCAD tumbles. The US dollar continues to lose major ground against all major currencies on expectations that the Federal Reserve will continue to cut interest rates through the medium term. Given that benchmark short term Canadian and US interest rates have recently hit parity, any further rate cuts would actually leave the Canadian dollar at a slight yield advantage to its US namesake. History has shown that currencies with inflation-adjusted yield advantages tend to outperform their lower-yielding counterparts. Thus it is likewise important to look at overall market US and Canadian yields as it relates to the US$/C$ exchange rate. Below we see a chart of the USDCAD plotted against the 2-year swap spread between the two countries.
The USDCAD unsurprisingly shows strong sensitivity to the relevant yield spread, as the 2-year swap rate gives us an accurate gauge of interest rate expectations for each respective economy. In this particular case, we see that the difference between Canadian and US 2-year swap yields is now firmly into negative territory. In other words, speculators predict that Canadian interest rates will be higher than their US counterparts through the next two years. Given that the Bank of Canada is widely expected to leave interest rates unchanged for some time to come, it is perhaps of little surprise to that 2-year CAD rates have remained relatively stable. Yet a recent rebound in relevant US yields leaves doubts as to the future of such moves. Fed Remains Dovish, but Can FOMC Continue Cutting Rates on Record Commodity Costs? Current outlook on US interest rates clearly leaves further room for dollar weakness. Yet that same dynamic has led dollar-denominated commodity prices significantly higher through the medium term. The US Federal Reserve is on a mandate to control inflation and maintaining long term stability in economic growth. Its decision to cut interest rates by a cumulative 75 basis points within two month’s time certainly suggests that the Fed stands ready to provide stimulus to broader economic growth. Yet the Fed may have considerably less room to cut interest rates further if such moves threaten to derail overall price stability. Despite cutting interest rates fairly aggressively in two months, fed officials clearly show concern that recent trends in commodity prices threaten to distort prices. In today’s FOMC statement, they said “Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.” Given concerns about price pressures—especially as they relate to commodity prices, it will be critical to gauge the effects of oil prices on domestic CPI.
Record Oil Prices Could in Fact Moderate USDCAD Declines Market focus on interest rates leaves the future of US inflation at the forefront of exchange rate considerations. Overall trends subsequently suggest that US Core Consumer Price Index levels will tend to rise when commodity prices press higher. Higher crude oil and gas prices will have a fairly immediate effect on headline CPI, while it will take more time for these effects to trickle into prices outside of volatile food and energy costs. The US Federal Reserve is fully cognizant of this fact, and it will definitely be reluctant to cut rates aggressively in the face of mounting Core CPI pressures. Given the prospects of relatively stable US interest rates, the Canadian dollar may lose a key pillar of strength against its US namesake. Trading Opportunity Already we see markets scale back expectations for further US interest rate cuts. The Canadian dollar has nonetheless surged to fresh heights against the greenback—showing few signs of slowing its ascent. We will continue to watch for sentiment extremes and other signs that the trend may be turning. Yet we clearly hesitate to advocate a Canadian dollar short (USDCAD long) near current levels. Instead, we will keep the trader posted on potential turning points for the Canadian dollar in our weekly Commitment of Traders Futures Positioning report and Daily Technical Strategy publications.