Following a rapid appreciation amid the subprime-fueled dollar selloff, the Canadian dollar settled into a range against its US counterpart, oscillating around parity between 1.0360 and 0.9740. This is not surprising given that nearly 80% of Canadian exports are destined for the US market, making Canada highly sensitive to the slowdown in the States. Canadian firms saw growth in export volumes tumble nearly 215% from their 2007 high in March to reach the lowest readings in 6 years by December. Output followed suit, with the pace of GDP growth slowing by over 35% in the final two quarters of 2007. The Bank of Canada followed closely after the US Federal Reserve to cut borrowing costs as the economy sagged (see Figure 1). The symmetry in the impact of the US crisis on both North American economies and the resulting symmetry in monetary policy have locked USDCAD in place.
[B]Canadian Exports Will Continue to Suffer in 2008[/B]
On the face of it, matters began to improve in the first quarter of this year. Headline export metrics bounced back smartly, posting a cautious expansion of 0.2% in the year to February after a -10.7% contraction in December. Given such readings, one would suspect the economy is on the come-back trail. And yet, things are not as rosy as they seem: annualized first-quarter GDP growth fell to just 0.8%, the lowest since 2001. Surely, an improvement in exports is supposed act positively on the overall trade balance thereby elevating GDP higher, so why the doom and gloom?
Evidence suggests the headline exports figure is misleading, inflated higher by the break-neck oil rally. Specifically, the price of crude added another 26.5% from peak to trough in the first quarter. Canada is the premier supplier of oil to the United States: petroleum products account for a whopping 24.2% of all Canadian exports to its Southern neighbor. A casual look at the trajectory of Canadian exports to the United States vis-à-vis the price of crude reveals a relationship apparent to the naked eye (see Figure 2). Removing oil and automotive goods (to filter out unwanted distortions from a strike at a US auto parts producer that disrupted shipments) reveals that the trajectory of core exports is decidedly downward (see Figure 3). Therefore, the come-back in export growth is accounted for by rising crude prices rather than an actual increase in the volume of goods shipped across the border. With little to suggest that the US consumer will return in force any time soon, Canadian exports and by extension the economy itself will continue to struggle.
[B]BOC Rate Cuts End Abruptly, Policy Following the US Fed[/B]
The BOC followed the Federal Reserve’s shift of policy away from deteriorating growth to inflation stoked by booming oil and food prices. For his part, Fed Chairman Ben Bernanke ended monetary easing in June citing that the “latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.” He added that “[the Fed] will strongly resist an erosion of longer-term inflation expectations, as an un-anchoring of those expectations would be destabilizing for growth as well as for inflation.” The BOC’s Mark Carney followed suit, surprising the markets on June 10th by opting to forego the expected rate cut and changing the accompanying rhetoric to project a decidedly hawkish tone. The bank noted that “many” of the previously feared risks to growth have moderated in recent months and revised GDP projections upward in both 2008 and 2009. Meanwhile, Carney warned that inflation could reach 3% this year assuming energy prices persist at current levels. The statement concluded that the current policy rate was “appropriately accommodative”, suggesting rate cuts were over for the time being.
[B]Oil Will Cause USDCAD To Break Above The Current Range[/B]
The above analysis of trade and monetary policy trends suggests little will change in the underlying fundamentals driving USDCAD. Poor performance in the export sector will continue to drag down the Canadian economy along with that of the US. A static yield gap lends further credence to the persistence of a range bound scenario. Even so, there is compelling evidence that these forces will take a back seat to another catalyst – the end of the oil rally.
All signs point to the conclusion that the fundamentals of crude production and consumption are not behind the current rise in prices. Rather, the current rally is primarily driven by speculative bets against the US dollar. As stocks fell to risk aversion and the US dollar tumbled, traders were desperate for a refuge destination to protect their assets. Blossoming demand for commodity imports from emerging markets such as India and China offered a rare positive story in an otherwise shaken marketplace, attracting huge inflows of speculative capital and leading prices to balloon higher. A report from the Organization of the Petroleum Exporting Countries (OPEC) was explicit in saying that “the falling value of the US dollar has encouraged inflows of new money into the crude oil futures market…Crude oil prices have become detached from the dynamics of supply and demand fundamentals, since, in spite of the persistent price rises, the market remains well-supplied with crude.” In point of fact, the inverse correlation between the rate of change in the dollar index and that of the price of oil is at the highest in over a decade.
With economic slowdown spreading globally, it is reasonable to think that traders will shift focus from looking for places where the crisis isn’t to those where it will end first. The proactive monetary and fiscal response to current issues on the part of American authorities makes it likely the US will lead the recovery while other countries lag behind. Further, US Treasuries will be bought as a standby safe-haven asset in a global decline scenario, prompting an inflow of capital into US debt markets. The absence of further interest rate cuts (and possibly even a rate hike) will bolster the greenback’s strength via a re-alignment of yield gap expectations. These factors will prompt investors to buy dollars, with the subsequent appreciation in and of itself depressing oil prices as the dollar regains purchasing power.
USDCAD will push higher as the rally in oil prices reverses. Historically, the Canadian dollar has been highly correlated with crude, seeing the two tracking each other with over 80% precision. The relationship has been particularly notable in the USDCAD pair because the global price of oil is denominated in US dollars. If the Canadian dollar is over 80% correlated with the price of crude, then one would reckon that an appreciation in oil would see an analogous depreciation in USDCAD over 80% of the time. This correlation has been weak of late as oil made outsized leaps to record levels. However, history teaches that similar divergences in the recent past have been followed by sharp corrections (see Figure 4). As the markets return to buy the dollar, the appreciation will blow the speculative froth off crude and send USDCAD higher as oil drops. This will realign the current divergence, making for a lucrative trading opportunity.
[B]Canadian Dollar Trend Depends upon Oil vs. Growth [/B]
Canada’s export sector has been badly hurt by slowing demand in the United States. This has dragged down overall GDP growth, suggesting the close trade relationship will see the two North American economies rise and fall together. The Canadian dollar has faithfully reproduced the pattern, oscillating in a narrow range against its US counterpart since December. Ranging conditions have been reinforced by the Bank of Canada’s emulation of the US Fed’s monetary policy, leaving interest rate expectations at a standstill.
Although headline export figures improved in the first quarter, the increase is rooted in rising oil prices rather than recovering US demand. In fact, there has been no substantial evidence suggesting any forthcoming changes in the trade or monetary policy dynamic.
While this ought to point to a continuation of range-bound trading, we see USDCAD break higher driven by a correction in the recent breakdown of the pair’s historic correlation with the price of oil.
The current rally in crude prices has been primarily driven by speculative bets against the US dollar. We see investors re-appraise the greenback in the coming quarter as hopes that the world economy will decouple from that of the United States are finally abandoned in favor of a widely accepted global slowdown scenario. In this instance, US assets will be bought as a safe-haven investment vehicle, with the subsequent dollar appreciation driving USDCAD higher as oil drops from its record highs.
[B][U]USD/CAD Technical Outlook[/U][/B]
[I]By Jamie Saettele[/I]
The USDCAD should higher in a C wave from .9710. The structure of the rally from .9055 has cleared up. A triangle is unfolding as an X wave (triangles can only occur as B waves, 4th waves, or X waves), indicating that the next move is higher in wave Y. A target for wave Y is 1.0800/50. 1.0866 is the 8/16 high, 1.0849 is the 61.8% extension of wave W (extended from 1.0047, which is presumed to be the end of the triangle as of now) and 1.0798 is the 61.8% retracement of 1.1875-.9055. The rally to 1.08 will complete a correction from .9055 (since the advance will be in just 3 waves) and likely lead to a new low (below .9055) to complete the entire drop from near 1.60.
