We know the CAD is a commodity currency that often fluctuates with the price of oil, however, have you ever stopped to consider why this correlation exists and is widely accepted as a constant? Keep reading as our Senior Corporate Dealer, Steve Kulchyk, explains.
Explaining the CAD and WTI relationship
In the past, we have seen a very strong correlation between oil and the Loonie. This comes on the back of oil making up a very large percentage of Canadian exports over the years. However, with pipeline capacity remaining nearly stagnant over the past few years, global oil demand increasing, and the current federal government’s reluctance to support the oil sands in Alberta, the Loonie has experienced more of an impact from foreign investment and economic fundamentals than we’ve seen in the past.
This is not to say that the correlation has broken down completely, as we have seen moves in CAD that correlate to large swings in WTI. However, context is the key to determine whether the Loonie’s move is due to a move in oil or if there is an underlying risk move that is causing the currency to fluctuate.
Why does the correlation fluctuate?
The Loonie tends to flip-flop between trading as a commodity currency and a North American currency. Over the past few years, especially now that central banks are holding interest rates for the foreseeable future, it has been trading as a risk currency. This means that any good news either economically or geopolitically has had a positive effect on the currency. Oil itself is a risk asset, whereas the demand increases the less risk is evident. This tandem move is enough for many to assume that this is a mutual relationship, however, this theory breaks down when we see moves in oil due to surprises in supply data. The same is true for the Loonie, where changes to Canadian interest rates have caused quite a bit of currency volatility but have had no effect on the price of oil.
When developing a view on a particular currency pair, it is always important to understand the underlying factors affecting moves in both of its respective currencies. That means that whatever currency we are comparing the Loonie to should be seen as the most important factor in building your own view. Take the US dollar, for example, the highest traded currency against the Loonie. The US dollar is a safe haven currency, however, in ordinary times it also reacts to economic fundamentals. Even if the correlation between CAD and WTI were higher, you must always factor in the changes in the relative strength of the currency you are comparing to. Using one factor to determine volatility could lead to a missed opportunity down the line.
“Even if the correlation between CAD and WTI were higher, you must always factor in the changes in the relative strength of the currency you are comparing to. Using one factor to determine volatility could lead to a missed opportunity down the line”
What to keep an eye out for when trading CAD
The coming weeks could spell a change in the Loonie strength trend. While positive equity markets and increased flight to risk assets have helped the Loonie outperform many of its peers, markets seem to be starting to gauge currency strength based on the expected timeline to full vaccination against COVID-19, something Canada is trailing behind in. It is still too soon to tell if this storyline has taken a firm grasp on the Loonie. Assuming it is still acting as a risk currency it is important to stay caught up on equity markets, as well as keeping an eye on new articles outlining any sort of geopolitical risks that may arise in the coming months. The biggest storyline right now from a liquidity perspective is the new US stimulus bill that is on pace to be confirmed on February 26th. Once central banks start to show activity once again, we will likely see a move back to interest rate-based currency moves.
To keep a close watch on the CAD, check out our currency monitor. If you are looking to find out more about payments or risk management, contact a moneycorp specialist who can offer you personalized services and tailor-made solutions.
More About Steve Kulchyk
Steve Kulchyk is a Senior Corporate Dealer in Canada for Moneycorp. He has 7+ years of experience helping companies mitigate foreign exchange risk and optimize payment cycles. He has worked with many Canadian businesses both private and publicly traded, including some household names. Steve takes pride in understanding his clients’ goals and helping them determine the FX products and policies that make sense for their business. In his spare time, he likes to spend as much time as he can with his wife and 9-month old daughter.
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