Oil rally may stabilize Canadian dollar

The Canadian dollar’s performance has been closely tied to monetary policy expectations ever since the Bank of Canada first hinted that interest rates could be on the rise back in June. But it may be time for oil to reassert its influence on the loonie.

Prior to BoC senior deputy governor Carolyn Wilkins’ speech in Winnipeg this summer, markets were pricing in zero chances of a 2017 rate hike in Canada. However, after she indicated a rate lift-off could come in July, the BoC followed up with what some considered a surprise second hike in September, and since then, the rate outlook has dominated trading in the loonie.

While the recent volatility in the Canadian dollar appears to be driven primarily by short-term rate expectations, Scotiabank believes the loonie is poised for stabilization or improvement as a result of stronger commodity prices.

Shaun Osborne, the bank’s chief currency strategist, isn’t all that concerned about the sliding Canadian dollarcrude oil correlation, which recently hit an almost threeyear low.

“We expected the linkage to reassert itself once crude oil broke out of its flat trading range between (roughly US$40-US55 per barrel),” Osborne said. “That time may be now.”

A closer look at price trends showed commodities important to Canada have been doing better than their international peers since early 2016. The strategist highlighted the Thomson Reuters CoreCommodity CRB Index’s roughly 17 per cent gain since January 2016, which compares to a 55 per cent surge in the BoC’s average commodity price index. That’s been supported by both the rally in oil prices, and a more than 40 per cent gain in the forestry prices index.

“Rising commodity prices have delivered a significant boost in Canada’s terms of trade, meanwhile, which we expect will support for the CAD,” Osborne said, adding that this implied relatively stronger export prices and higher domestic real incomes.

The strategist noted the loonie started to become detached from improving domestic terms of trade in late 2016, when investors started to anticipate the election of Donald Trump would boost growth, speed up Fed rate hikes, and bolster the U.S. dollar. With that argument having lost much of its lustre, interest rate spreads should stabilize in the coming months, and that should allow commodity prices to have a bigger impact on the Canadian dollar.

“We remain bearish on the USD from a longer-term point of view and think Canada institutional investors should remain underweight USD relative to benchmarks,” Osborne said.

“At the very least, we think improving terms of trade and firmer commodity prices will help offset positive (seasonal, fundamental) USD impulses into year end to some extent and reaffirms our conviction that USDCAD will struggle to extend much (or at all) above recent highs,” the strategist added.