By Michael O’Neill

The days of rising oil prices boosting the Canadian dollar are over for now. That is going to change but it won’t happen soon enough to influence the currency this year.

Canadian government policies villainized the domestic oil industry as they adopted a series of “green” initiatives that chased away foreign and domestic investment since 2015. Those policies left Canada unable to exploit its roughly 165 billion barrels of proven oil reserves worth around $16.5 trillion US dollars at today’s prices. There is still hope.

Prime Minister Mark Carney, a noted eco-warrior and climate evangelist, is discovering that governing an energy superpower requires a different skill set than lecturing one. Faced with slowing growth, fractured North-South trade, and rising geopolitical tension, Ottawa appears increasingly willing to trade climate purity for pipelines and production growth. Surging demand for secure energy supplies is forcing the issue.

Carney’s government is now openly embracing what it calls a “values-based realism” strategy, acknowledging the “hard reality” that Canada must utilize all available energy sources, including natural gas, while still pursuing longer-term climate objectives.

Behind the scenes, Ottawa is constructing the institutional machinery to accelerate major energy and infrastructure projects, including a new Major Projects Office tasked with streamlining approvals for more than $126 billion worth of infrastructure, mining, and energy developments.

US Inflation Hitting Hot Zone

Trump’s Iran folly is taking a big bite out of the disposable income of Americans, Canadians, and the rest of the world. Warnings that the oil price shock following the effective closure of the Strait of Hormuz would fuel inflation are now bearing fruit. Yesterday, US inflation measures rose more than expected. The increase in core CPI, which excludes food and energy, showed that price pressures were expanding beyond energy. US Producer Prices surged 1.4% in April, nearly triple what had been expected, and those increases will eventually be passed along to consumers.

The combination of the two reports sparked a jump in 10-year Treasury yields to 4.492% at the peak today. If inflation data remains hot, the Fed’s next move may not be a cut at all. CME FedWatch pricing is becoming increasingly hawkish, with markets even beginning to flirt with the possibility of another rate hike by next March.

That’s bad news for bears, the US dollar kind, and the Loonie as well.

Helter Skelter

The Bank of Canada has flagged a worsening output gap as a major economic problem, with per capita growth lagging every other G10 economy by a significant margin. The pending CUSMA renegotiation threatens to deepen that structural underperformance. Adding a widening CAD/US interest rate differential into the mix puts the loonie on even worse footing.

That matters for Canadian dollar traders because investors chase yield, and the US 2-year yield is around 3.95% while the Canadian equivalent is near 2.98%.

For the loonie, the timing could hardly be worse.

Rock and a Hard Place

The Bank of Canada has spent months threading a difficult needle and is running out of thread. Governor Macklem floated the idea of raising interest rates two weeks ago, which, given the state of the domestic economy, is somewhere between puzzling and alarming. Canadian households are already stretched by debt, housing costs, and slower growth, and the pending CUSMA trade talks threaten to make a bad situation worse. Trump has Canada’s auto and dairy industries in his crosshairs, and nobody in Ottawa is pretending that is a minor inconvenience.

Raising interest rates into that headwind, especially with Canadian inflation effectively tamed, makes no sense. But the alternative is equally uncomfortable. Keeping rates on hold while the Fed drifts toward a hike widens the yield differential further, pressures the loonie through capital outflows, and imports inflation through a stronger US dollar. There is no clean option on the table.

That’s the spread the loonie is playing, and right now it is losing.