Deteriorating Canadian data has pushed USDCAD up against the key 1.06 resistance level once again, and if the pair manages to close above that mark, it will be the first time it has done so since 2010.

Many major currencies including the euro (EUR), British pound (GBP), and Japanese yen (JPY) spent the week trading in pre-existing ranges, but as this was happening, the Canadian dollar (CAD) experienced big moves. The loonie sold off aggressively this week, hitting a one-month low against the US dollar (USD) after breaking through 1.05, which is a significant resistance level in USDCAD.

Part of the reason why CAD performed so poorly is because oil is off its highs and the US dollar gained upside traction on the back of more tapering talk by the Federal Reserve. However, the real reason is domestic, and that can be a major problem for Canada and its currency.

Since the beginning of the month, we have seen a dramatic deterioration in Canadian economic data, but it took a while for USDCAD to gain traction. When it did, however, the move saw significant momentum, with the currency pair rallying for six consecutive trading days.

According to this morning's consumer price report, inflationary pressures in Canada are basically non-existent. Overall, prices rose 0.1% in July, but core price growth was flat. This inability to increase prices is consistent with other reports that showed the Canadian economy taking a serious hit last month.

As an export-dependent nation, Canada has been running a trade deficit since December 2011, and the outlook hasn't brightened. Manufacturers in Canada cut spending for the first time this year, according to the IVEY PMI report. At the same time, wage growth has been the slowest since 2011 and job losses last month were significant.

A slower recovery in the US is part of the problem, but Canada also had to contend with weaker output by the nation's oil and gas producers, flooding in Alberta, and a construction strike in Quebec that affected manufacturing activity and consumer consumption. As a result, the economy is expected to shrink this month, which would be consistent with the Bank of Canada (BoC) forecast for an expansion of only 1% in Q2, down from 2.5% in Q1. GDP numbers are scheduled for release next week.

For USDCAD, the question now is whether the deterioration in data will affect the BoC’s position and strategy. There is no monetary policy meeting in August, but when the central bank last met in mid-July, it appeared to be in no rush to raise rates.

Under former BoC Governor Mark Carney, the Bank had been saying that a "modest withdrawal will likely be required, consistent with achieving the 2 percent inflation target," but new Governor Stephen Poloz, who led his first meeting in July, adjusted the language to say that "over time, as the normalization of these conditions unfold, a gradual normalization of policy interest rates can also be expected, consistent with achieving the 2% inflation target."

The conditions he refers to include the amount of slack in the economy, the inflation outlook, and household sector financials. This left the bias of the central bank slightly less hawkish, a position it is comfortable with at this time.

Much of the factors weighing on the Canadian economy in July are temporary (floods, strikes), but depending on how Fed tapering impacts the US economy, the BoC could consider a more dovish stance.

The following monthly chart of USDCAD highlights its recent strength, and the currency pair is now poised for a test of its year-to-date high of 1.0610. The 1.06 level is extremely important because USDCAD has tested and rejected this level on numerous occasions.

Guest Commentary: USD/CAD Facing Major 1.06 Resistance

A_USDCAD_Move_3_Years_in_the_Making_body_GuestCommentary_KL_August23A.png, A USD/CAD Move 3 Years in the Making

The last time USDCAD closed above 1.06 was in 2010, and even then it struggled to extend its move beyond that level. The last time USDCAD saw a significant rally through the 1.06 level was in 2008 during the financial crisis. This year is very different from 2008, though, so we believe USDCAD could fail at the 1.06 level once again. However, if the pair does break 1.06 and manages to extend through 1.07, then 1.10 could be the next stop for USDCAD.

By Kathy Lien of BK Asset Management