Canadian Dollar: Higher or Head-Fake?

Mar. 2.11 | About: CurrencyShares Canadian (FXC)

The Canadian dollar made new highs Friday and Monday – seemingly due to the recent oil price spike. The Canadian dollar also has a well-known and long-standing link with the price of oil, so it pays for currency traders to be aware of the action in oil markets – and as you know, that action has been spectacular as of late.

We cannot help but wonder though: Where would oil be without massive riots engulfing the Middle East?

As recently as last week, WTI crude (West Texas Intermediate) couldn’t maintain a rally even with the threat of a revolutionary contagion spreading across the entire Middle East. It took actual widespread revolution in the Middle East just to push oil above $100. WTI closed well under $100 on Friday – blowing off a full weekend of revolution risk.

As far as I know, revolutions don’t take weekends off!

In other words: Despite the pyrotechnics, these moves seem more like passing jitters than a genuine mood shift in oil.

Other evidence: Oil prices for delivery one year out haven’t budged, even though spot prices soared 15% or more. The WTI contango (prices for distant future delivery more expensive than near delivery), which has defined the oil market for the last several months, has evaporated.

While moving out of contango would “normally” be interpreted as a bullish sign, multiple revolutions across the Middle East don’t qualify for “normal” at all. Shifts to new price regimes require the entire oil price curve to shift – which has not happened.

With huge, huge riots everywhere – and what appears to be a defacto overthrow of the Libyan government this weekend – we have WTI crude still wrestling with $100.

So there are at least two interpretations of the price action in oil:

  • The flow of oil will be interrupted long term: This is a move to a higher plateau of oil prices.
  • The flow of oil is likely to continue no matter who is in power: This is a blow-off top on unprecedented but mostly peaceful geopolitical action.

To me, the price action says “Flow of oil likely to continue no matter who is in power,” so let’s look at the impact of oil on the Canadian dollar.

Oil moving $13 is still $13, so you’d expect this to have an impact on the Canadian dollar. Oil and the Canadian dollar are widely considered to be strongly linked markets. When I do a bit of math, it seems like the move in the Canadian was “too small” relative to the huge increase in oil prices.

What do I mean by “too small”? We have years of a historical relationship between oil and the Canadian dollar. We have a strong indication of what “should” happen to the Canadian dollar with oil moving $1/barrel.

As it turns out, regression analysis says that for every $1/barrel move in oil, the price of the Canadian should move about 62 pips. This relationship is not absolute, and no market moves in complete lockstep. But it does give clues to what should be happening with the price of the CAD. Let’s use the oil lows from late January as a reference point.

  • Closing price Friday: 97.88.
  • Opening price from Jan. 28: 87.55.
  • Total Move: $10.33.

Based on the above, the Canadian dollar should have had a move of 10.33 * .0062 = 640 pips. We got a move of 250-300 pips.

This doesn’t take into account the huge move well above $100 a barrel that happened late last week and sold off – at one point the Canadian should have been up nearly 1,200 pips, but we've seen nothing in the CAD even close to this magnitude.

This discrepancy between oil and the Canadian dollar has been in place for the last six months. Oil and Canadian both made significant lows on August 26. But while the price of oil has rallied at least $27/barrel (from $70), the Canadian dollar has only rallied about half of what would have been expected.

I am using futures in the chart below – the CAD futures are inverted compared to the USDCAD. Mentally invert this chart if you’re used to looking at USDCAD.

[Click to enlarge]

Click to enlarge

We had similar price action during the 2008 oil price spike to $140. Oil went to $140, but the Canadian dollar hit 1.10 months before the spike, and actually started to fall once oil got above $90. By the time oil hit $140, the USDCAD was trading around 1.0000.

Clearly, something keeps a lid on the Canadian dollar when the price of oil gets too high.

The most obvious answer is that the market gets very concerned about U.S. economic growth when oil prices get too high. Since some large portion of Canadian economic activity depends on U.S. activity, oil prices above $90 are negative for the future of the Canadian economy too.

What is the upside here for the Canadian dollar? Further oil price increases are unlikely to give the CAD a boost in the short term. Additionally, the Canadian dollar has had a compressed range when compared with corresponding moves in the price of oil.

This is something to consider when looking at oil prices as a driver of the Canadian dollar – the CAD doesn’t seem to like oil above $90/barrel.

This doesn’t negate the higher movement of the CAD, but is rather something to watch as trading develops.

Disclosure: As active traders, authors may have positions long or short in any securities mentioned. Full disclaimer can be found here.