Oil
prices are on the rise once again and this time crude is setting fresh record
highs in the process. In the past month alone, crude prices have increased by a
whopping 21 percent, leading many to ask how much longer can this rally
continue. The latest round of oil strength stems fromIran
’s
announcement
that they have successfully enriched uranium for the very first time. Geopolitical tensions are rising as the
oil market fears that the US
may respond with an attack on Iran, the holder of the third largest
oil reserves in the world. The
US does not import any oil
from Iran, but many countries
such as Russia,
China and some European nations
do.
Retracement Waves in
Oil
If history is a reliable barometer,
then we expect another retracement “wave” in oil. According to the chart below, each rally
wave lasted only 2 months before reversing. We have just begun the second month of
the rally, which means that we could see a bit more of an extension, but the
additional percentage gain should be limited. However once the move lower occurs,
judging from previous retracement moves, we could easily see a $10 drop in crude
prices.
USD/CAD –
The trade to turn to if oil crashes
If oil
crashes, there will be ripple effects on many economies. In the Middle
East, a lot of wealth and home valuations are tied to oil, making it
even more important for those traders to look for hedging opportunities. The same is true here in North America.
Canada’s booming economy has been
fueled by the climb in oil which has benefited domestic corporate
profitability. It has also sent the
Canadian dollar to 28 year highs against the US dollar by boosting the
international purchasing power for Canadians. As the world’s second largest holder of
oil reserves, Canada has been one of the primary
beneficiaries, which means that if oil crashes, it will also be the currency
that will suffer the most.
In
contrast, the US stands to benefit greatly if oil
prices slide. For months now, there
has been a widespread fear that the rise in oil could weigh heavily on consumer
spending. With the housing market
bubble already posing a big risk for the economy, the potential impact of
skyrocketing oil on spending has been one of the biggest arguments against a
prolonged Federal Reserve tightening cycle. The lower the price of oil, the more
stimulative it is for the US economy as discretionary income of
US consumers increases. Therefore
if oil does crash, this fear of an economic slowdown will be greatly alleviated
and be taken as a promising sign by dollar bulls. Of course, this may bring up the question that since oil is priced in
dollars, why wouldn’t the dollar suffer from a decreasing value of oil
purchases. The answer is the same
answer as why the dollar does not benefit from the higher price of oil. It is because a lot of central banks
already have reserves in dollars and the same is true for companies, which means
that they do not need to convert additional money into dollars in order to fund
new purchases.
This
makes the long USD/CAD trade the perfect hedge against falling oil prices. The chart below shows the close
correlation between Oil and USD/CAD (inverted in graph). When oil prices rise, USD/CAD falls and
vice versa. Since the beginning of
2004, the correlation between these two products has been a strongly negative 86
percent. On top that, sliding oil
prices would bring about improvements to the US economy and the prospects for higher
US interest rates. For Canada
on the other hand, the Canadian economy would suffer and in the extreme
scenario, forcing the Bank of Canada to cut short their tightening cycle. In the extreme scenario, they may even
opt to reduce interest rates, which would hurt the Canadian dollar
significantly. For the time being,
the differential between the rates in the US and Canada is 100 basis points,
which means that for each day a trader holds one regular lot of USD/CAD on the
long side, the trader would earn $2.80 in interest income, a benefit that short
oil contracts do not offer. Therefore USD/CAD is a very interesting
trade to look into if you think the oil move is overdone and may due for a
retracement.
USD/CAD –
Already Battered
Furthermore,
USD/CAD is already trading not far from its 28 year lows, suggesting that
support may come in soon enough for the currency pair. It was only four years ago that the
dollar was trading at 1.60 against the loonie and we are already showing signs
that the sell off may be nearing an end.
For three consecutive months, USD/CAD has touched the same lows and
failed to break through, making it an even more attractive trade if you need to
hedge against a slide in oil.
Eventually, as oil continues to rise, the benefits for the Canadian
economy will also begin to subside.
The market tends to forget that Canada is also a huge net exporter to the
US. Therefore the stronger the loonie, the
weaker the exports. Canadian
automobile exports have already begin to suffer.
The
information contained herein is derived from sources we believe to be reliable,
but of which we have not independently verified. FXCM, L.L.C.® assumes no responsibility
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limitation losses, lost revenues, or lost profits that may result from these
materials. Opinions
and estimates constitute our judgment and are subject to change without
notice. Past performance is not
indicative of future results.
