- USD/CAD avoids the worst excesses of volatility in markets from the reported retaliation of Israel against Iran.
- The flight to safety boosted the US Dollar but the Canadian Dollar benefited equally from surging Oil prices.
- Interest rate differentials remain a bullish factor for the pair as the Fed delays expected interest rate cuts.
USD/CAD is trading in the 1.3750s after edging lower on Friday. The pair has been shielded by the worst excesses of volatility witnessed in markets brought on by the escalating geopolitical situation in the Middle East.
The surge in risk aversion after reports of Israel’s retaliatory attacks on Iran have supported the safe-haven US Dollar (USD) along with the other usual suspects: Gold, JPY, CHF.
Yet the impact on USD/CAD was muted due to the Middle East conflict’s impact on Oil, and the Canadian Dollar’s sensitivity to Oil prices.
WTI Crude Oil prices rose over 4.0% from $81.80 to $85.50 following the news of Israel’s purported attack on Iran. This strengthened CAD because Oil is the country’s primary export.
Beyond the Israeli-Iran conflict, however, other factors are also expected to drive up the price of Oil, according to some analysts.
One factor is the US’s increasingly long list of Oil producing countries who are potential targets for sanctions.
“Less Oil from Iran and Venezuela is likely to reach the market in the coming months, as the US intends to tighten Oil sanctions against Iran and reinstate the Oil sanctions against Venezuela that have been eased in the meantime,” says Commerzbank in a recent note.
Commerzbank sees other bullish factors for Crude in the form of continued OPEC+ supply constraints and increased broad demand for gasoline due to the likelihood that the European Central Bank (ECB) and Federal Reserve (Fed) will start cutting interest rates before the end of the year.
From the perspective of Oil, the outlook favors the CAD side of the USD/CAD pair, and is therefore a bearish factor for USD/CAD.
Diverging outlook on interest rates could support USD/CAD
USD/CAD remains in a short and medium-term uptrend despite the negative spillover effect from Oil prices.
The reason for this is the diverging outlook on the future path of interest rates in the US and Canada. Interest rates are a key FX driver because global capital tends to flow to where interest rates are higher all other things being equal.
This has supported the US Dollar most recently during its early April rally and provided a bullish backwind for USD/CAD.
Interest rates in Canada are expected to fall in the summer amid declining inflation and slower growth but the reverse is increasingly the case in the US.
In the US stronger macroeconomic data, persistently high inflation and a tight labor market are seen as factors likely to keep interest rates comparatively higher for longer.
From expecting three 0.25% rate cuts in 2024 at the start of the year when inflation was tracking lower, the Federal Reserve is now indicating it may only cut twice or perhaps once. Some Federal Reserve officials are even signaling that the central bank should keep interest rates at their present level until more evidence of inflation coming down is available.
Market based indicators of the number of rate cuts have also changed radically with odds now showing the most likely month for the Fed to implement a first rate cut is September, when previously expectations had been zeroed in on June.
The situation in Canada is very different. There, inflation is still tracking lower and the probability of the Bank of Canada (BoC) cutting interest rates by 0.25% in June stands at 70%, according to analysts at Brown Brothers Harriman.
Indeed, on Tuesday, BoC governor Tiff Macklem stated, “there’s some downward momentum in underlying inflation.”
Canadian Consumer Price Index (CPI) data backs this up. Whilst headline inflation crept higher in March – to 2.9% from 2.8% it remains below the BoC's 3.0% target. In addition, the main drivers were rising gasoline prices and the rising US mortgage rates used by many Canadian property owners, according to Tradingeconomics.com.
Both the core-trim and core-median measures of the Consumer Price Index (CPI), however, showed signs of easing – to 3.1% (the lowest since June 2021) and 2.8% (matching the July 2021 low), respectively – according to BBH.
Canadian Dollar FAQs
The key factors driving the Canadian Dollar (CAD) are the level of interest rates set by the Bank of Canada (BoC), the price of Oil, Canada’s largest export, the health of its economy, inflation and the Trade Balance, which is the difference between the value of Canada’s exports versus its imports. Other factors include market sentiment – whether investors are taking on more risky assets (risk-on) or seeking safe-havens (risk-off) – with risk-on being CAD-positive. As its largest trading partner, the health of the US economy is also a key factor influencing the Canadian Dollar.
The Bank of Canada (BoC) has a significant influence on the Canadian Dollar by setting the level of interest rates that banks can lend to one another. This influences the level of interest rates for everyone. The main goal of the BoC is to maintain inflation at 1-3% by adjusting interest rates up or down. Relatively higher interest rates tend to be positive for the CAD. The Bank of Canada can also use quantitative easing and tightening to influence credit conditions, with the former CAD-negative and the latter CAD-positive.
The price of Oil is a key factor impacting the value of the Canadian Dollar. Petroleum is Canada’s biggest export, so Oil price tends to have an immediate impact on the CAD value. Generally, if Oil price rises CAD also goes up, as aggregate demand for the currency increases. The opposite is the case if the price of Oil falls. Higher Oil prices also tend to result in a greater likelihood of a positive Trade Balance, which is also supportive of the CAD.
While inflation had always traditionally been thought of as a negative factor for a currency since it lowers the value of money, the opposite has actually been the case in modern times with the relaxation of cross-border capital controls. Higher inflation tends to lead central banks to put up interest rates which attracts more capital inflows from global investors seeking a lucrative place to keep their money. This increases demand for the local currency, which in Canada’s case is the Canadian Dollar.
Macroeconomic data releases gauge the health of the economy and can have an impact on the Canadian Dollar. Indicators such as GDP, Manufacturing and Services PMIs, employment, and consumer sentiment surveys can all influence the direction of the CAD. A strong economy is good for the Canadian Dollar. Not only does it attract more foreign investment but it may encourage the Bank of Canada to put up interest rates, leading to a stronger currency. If economic data is weak, however, the CAD is likely to fall.
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