Cauliflower became the poster boy for a weak Canadian dollar in January- Photo: Shutterstock

Do you remember the Canadian dollar free-fall in January? The country was going to hell in a barrel of crude and the price of cauliflower was the yardstick to measure the depths of our despairDidn’t happen. It was all just a bad dream. At least that is the conclusion one can draw from the current level of the Canadian dollar which is back to where it started the year.

There is no doubt that the dominate driver of USDCAD direction is oil price direction, specifically West Texas Intermediate. (WTI) But it would be a mistake to view USDCAD solely in the context of oil.  US Federal Reserve interest rate intentions and the health of their economy dictate global US dollar moves and the Canadian dollar is vulnerable to sentiment swings. That also ties in with expectations for the European Central Bank’s stimulus plans. And then there are the domestic influences with the Bank of Canada’s outlook and intentions being key.

Crude Mood Skewed

WTI hit a 13 year low when it dealt at $26.05 /b on Tuesday February 16 due to on-going concerns of over-production, reduced demand and rising storage capacity constraints. Then suddenly, those fears were forgotten. Widespread rumours that the major oil producers, including Russia, were going to meet to discuss production caps sparked a WTI rally, gaining 11.4% in two days. The oil rally spread to other markets helping commodity currencies and global equities to post gains. It didn’t last and by mid-morning Friday, WTI was back down to $29.40/b.

In reality, the oil price gains were always doomed to fail due to the following:

1. Although the rumours and talks about Russia and Opec nations discussing production caps proved to be true, they were missing a key participant; Iran.
2. Iran had previously stated that they wouldn’t consider any oil price support plans until they had achieved pre-sanction production levels, which are around 3.1 million barrels per day. (mb/d) In September, 2015, Iran’s Minister of Petroleum bragged that Iran will produce 4.2 mb/d by the end of 2016.
3. US crude inventories are still growing indicating that supply continues to out-pace demand. On Thursday, the Energy Information Administration (EIA) reported US crude oil and gasoline inventories rose to record highs in the week ended February 12.
4. The Organization for Economic Cooperation and Development (OECD) downgraded their forecast for world economic growth in 2016, projecting 3% growth, the slowest pace in 5 years.
5. WTI technicals are bearish. The June 2015 downtrend remains intact while trading below $38.50/b and the downtrend following the November Opec meeting is still in place while prices are below $32.60/b

 Loonie is punching above its weight

Just as USDCAD may have overshot to the topside in January, the February decline may be an over-correction, as well. There are a lot of reasons to support the view that USDCAD has over-corrected.

1. The Canadian economy is sputtering. Alberta has been decimated. Analysts at CIBC wrote last week that they were concerned about Canada slipping into a recession, citing a decline in real GDP (GDP adjusted for inflation) and a rise in unemployment.
2. Weak domestic data including Friday’s Retail Sales which showed a decline of 2.2% in December sales, ex autos is further evidence of a sputtering economy that may be on the verge of a recession. The Organization for Economic Cooperation and Development (OECD) downgraded Canada’s economic growth to 1.4% from 2.4% on Wednesday.
3. There is a rising risk of a Canadian interest rate cut. The Bank of Canada (BoC) declined to lower interest rates in January (apparently it was a very close call) preferring to wait until  the Federal budget and its fiscal stimulus is announced. Another factor in delaying a cut was the strength of USDCAD at the time.  The BoC did not want to exacerbate the fall in the Canadian dollar.  It’s a different story today-USDCAD is over 0.0850 points lower than it was on January 21
4. General US dollar strength. US rates are going higher in 2016, the Federal Open Market Committee said so. The issue is how high.  Is it just a ¼%, 1% or somewhere in-between?  Japan has negative rates, so does Switzerland and the Eurozone.  China is doing everything it can to stop its economic slowdown including devaluing their currency. Higher US rates makes the dollar attractive and undermines the Loonie
5. Geopolitical tensions have increased. The Syrian civil war is threatening to suck Turkey into the hostilities while Russia’s action’s to support the Syrian government pit them against NATO. ISIS has expanded its terror distribution methods.  Iran and Saudi Arabia are far from cordial. North Korea is testing mini H-bombs and missile launchers. And China is having its way in the South China Sea, reportedly deploying missiles on man-made islands in an effort to dominate the area.  All of the above can trigger safe-haven demand for US dollars at any time, to the detriment of the Canadian dollar.

Year of the Monkey, Month of the Loonie Bear

On January 20, 2016, WTI made a 13 year low at $26.80.  Coincidently USDCAD made at 13 year high at 1.4666.  On February 11, 2016 WTI made another 13 year low when it dealt at $26.02/b but this time USDCAD could barely crack above 1.4000.

Something is definitely out of whack and that something is the Canadian dollar. Arguably the USDCAD decline was so sharp, steep and fast because it was a capitulation of the long-held bullish USDCAD trade. These positions had grown very large, very stale and were compromised by “Johnny-come-lately’s” who may have entered into positions and poor levels. The BoC’s decision to leave rates unchanged coupled with a rebound in WTI precipitated the decline. In addition, poor liquidity served to exaggerate the move.

Oil prices remain in a downtrend.  Iran says it plans to boost production to pre-sanction levels, the Saudi’s have no intention of reducing their output, an agreement to cap production has failed to materialize, US storage supplies continue to increase and the global economy is expected to continue to slow. That means that even if oil prices do not make new lows, top-side gains are likely limited as well

It may be the Year of the Monkey but it will also be the Month of the Loonie Bears. In this environment of soft oil prices with a prospect for even lower levels, a sputtering Canadian economy with a risk of a rate cut, and the possibility of a hawkish sounding Fed, there is only one way for USDCAD to go, and that is up.