USD/CAD has been falling with higher oil prices, driven by tensions between the U.S. and Iran.
However, with recent feedback from President Donald Trump, it would appear that these tensions are softening. Oil prices have sharply responded by dropping quickly.
This fall in oil prices has enabled oil-exposed Canada (exposed via exports) to see its currency fall, in line with the drop in oil prices.
As short-term interest rate spreads are close to zero for the USD/CAD pair, one key risk lies in the upcoming January 22 and January 29 central bank meeting dates of the Bank of Canada and Federal Reserve, respectively. Any inharmonious changes could disrupt the otherwise neutral status quo for USD/CAD.
Meanwhile, any increase in tensions between the United States and Iran could spike the oil price again, which could potentially send CAD higher and therefore USD/CAD lower. The USD/CAD status quo is generally neutral, owing to their positive economic and interest rate correlations. However, risks remain in the potential for near-term monetary policy divergences or geopolitical issues. Cautious optimism is suggested.
The USD/CAD currency pair, which is the United States dollar expressed in terms of Canadian dollars, has demonstrated a strongly negative trajectory since late November 2019, and remains apparently trapped within a bearish trend ever since the end of 2018.
This bearish trend is illustrated in the chart below, which uses daily candlesticks. Notice that the current price of USD/CAD is well off the highs seen at the end of 2018 and beginning 2019, when the pair was able to trade above 1.3650.
(Chart created by the author using TradingView. The same applies to subsequent candlestick charts presented herein.)
We can see that the spread between the short-term interest rates offered by these two countries' one-year government bonds has also dropped. Comparing the difference between U.S. rates and Canadian rates (to be used as a proxy), we can gauge the carrying value of this pair over time.
The higher the spread, the more valuable, and vice versa. This is because currencies with higher interest rates (relative to other currencies) offer traders higher levels of carry. In this case, an evident reason for the downside we have witnessed in the USD/CAD pair becomes clear: the positive interest rate spread has totally eroded over time (in the chart above, the implied spread is in fact negative at -0.16%; see the red line, set against the far-right y-axis).
We can compare this spread, which is essentially priced in by the bond market, with the rates set by the central banks of these countries. The table below shows these (highlighted in red, by the author).
However, bear in mind that the +1.75% current rate of the Federal Reserve shown in the table above is the top of a target range which spans between +1.50% and +1.75%. If we take a midpoint, which would be about 163 basis points (positive), and subtract 175 basis points to factor in the Bank of Canada's short-term rate (which is also positive at +1.75%), the implication is a net "borrowing cost" (negative carrying value) of approximately -12 basis points.
In the prior chart, which provided the one-year yield spread as priced in by the market, we saw a negative implied spread of -16 basis points. It would appear that, all considered, the bond market is adequately priced. As also shown in the table above, this dynamic could potentially change on either January 22 (when the Bank of Canada's next meeting is) or on January 29 when the Federal Reserve could decide to change their target rate.
If both banks hold rates at their current rates, we could possibly see some consolidation in USD/CAD but with a bullish tilt. This is because the bond market has mostly priced in the status quo; a continuation of the bearish trend would probably require a further downgrade in interest rate differentials. The reason is because while the spread is arguably negative (if a midpoint is taken for the short-term U.S. target rate), the spread is so close to zero as to be uneconomical to exploit from a carry-trade perspective.
In other words, if rates are held steady in both cases, we are likely to see greater focus (from the market) being placed on the words of the central banks, in terms of future guidance for instance. For USD/CAD, it is all about the future.
This latter point admittedly applies to all currency pairs, but to varying (and mostly lesser) extents. The 'status quo' looks a lot different in other places in the foreign exchange market. For example, as I wrote in a recent article, the bias for USD/CHF is clearly to the upside, owing to a large interest rate spread (relative to other major currency pairs) whereby U.S. central bank rates of +1.50 to +1.75% compare to the negative rates as set by the Swiss National Bank of -0.75%. As Switzerland is not producing positive inflation, the status quo is likely bullish for USD/CHF (i.e., bearish for CHF).
As the rates for USD and CAD are roughly similar, the bias is mostly neutral. We can, however, notice that Canada recently beat the U.S. on the basis of quarterly GDP growth (net of inflation, see here). In the third quarter of 2019, the United States produced real GDP growth of +2.1%, versus Canada's rate of +1.6%. The countries produced similar levels of inflation in this quarter (+2.1% in the U.S.; +2.2% in Canada). The economies are positively correlated, and frankly "neck-and-neck" in terms of performance.
Because of that, we can also guess that it is probable that if one of these countries' central banks decides to cut rates, the other bank is likely to follow suit. The same could be said for rate hikes too. In any case, this author believes that the status quo is likely to remain for the time being, but with oil prices recently dropping quickly (after the market perceived a lesser chance of U.S.-Iranian tensions escalating, following President Donald Trump's speech on January 8, 2019) the Canadian dollar may be at risk of near-term weakness.
This is because Canada exports a significant amount of oil products, enough for the Canadian dollar to loosely correlate positively with oil prices (making it somewhat of a "commodity currency"). In the interim, if oil prices stabilize around current levels (WTI crude oil prices are likely around $60 per barrel), the CAD could ease off against the USD, sending USD/CAD higher off current levels. The chart below shows this dynamic between USD/CAD spot prices (see the daily candlesticks) versus WTI oil prices (see the red line; inverted)
On balance, we should see little reason for the USD to sell off too much further against the CAD. Both are nearing central bank meetings, with relatively equal short-term rates at present, and similar real economic growth rates as economies. If risk sentiment continues to improve after recent U.S.-Iranian tensions, the USD could see further strength. If escalations continue, oil prices could spike higher again, which could indeed send USD/CAD lower driven by CAD strength; this, however, is not a base-case scenario (war, thankfully, is rarely a base case).
In summary, we should see a consolidation of USD/CAD around current levels, and/or possibly see further upside as risk sentiment improves and oil prices continue to stabilize. On the other hand, any surprise moves by the central banks of the U.S. and Canada (such as a rate hike by Canada on January 22, or a rate cut by the U.S. on January 29 that does not follow on from a rate cut by Canada) could send USD/CAD downward significantly, as could further surprise moves (or attacks) on the U.S. from Iran.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.