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Apr 16, 2018

Keep an eye on loonie and oil becoming ‘friends again’: Currency strategist

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With the Canadian dollar recently rising to its highest point since February amid heightened oil price volatility, the loonie and oil are starting to look like friends again, according to one currency strategist.

CIBC’s head of North America foreign exchange strategy Bipan Rai said in a note Monday that it’s hard to ignore the pick-up in short-term correlation between the loonie and crude oil.

“So after a year of largely uncorrelated activity, are the Canadian dollar and crude oil back to being friends again?,” Rai said. “[This could be] thanks to NAFTA risks falling at the same time as geopolitical risks are rising.”

While NAFTA risks fading may be one reason why the loonie is moving in reaction to oil, Rai said that strength of the correlation between the two depends on “ebbs and flows.”

“If crude prices are falling from $100 per barrel to $30 per barrel, realized volatility in oil is high, investment in the sector dries up and domestic demand falls. Given the negative implications for growth if your country is a producer, it makes sense for the currency to weaken,” he said.

“The reverse is true when prices are rising. Alternatively, if crude prices are range bound then oil volatility will be low and the currency will be driven by other factors.”

West Texas Intermediate (WTI) crude oil and Brent crude have recently surpassed key resistance levels with volatility rising, Rai said.

Oil prices climbed nearly 10 per cent in the lead up to the air strikes on Syria over the weekend, as investors bought safe haven assets like gold and U.S. Treasuries to hedge against geopolitical risks.

“As a result, the Canadian dollar/crude correlation is firming,” Rai said. “A cursory glance at the technical charts implies a breakout target of $74 for WTI which should support a U.S. dollar/Canadian dollar move towards our target of $1.2485 and potentially an extension towards the $1.2400 area.”

LACKING FUNDAMENTALS

But Rai also said that there were important reasons “not to misinterpret the existing relationship” between oil and the loonie.

He said the co-movement between the two was largely due to the “proxy effect,” which means oil volatility and prices rising meant “the market chases a stronger Canadian dollar rather than fundamentals.”

“It’s worth keeping an eye on the correlation between oil and the Canadian dollar – especially if oil prices keep breaking out higher,” Rai added. “However, it’s important to remember that co-movement is likely reflective of proxy effects or a common principle driver rather than fresh investment into the oil sector.”

Statistics Canada released a survey in February showing that investment intentions in the Canadian oil patch will decline about 12 per cent in 2018 compared to last year.

Mark McCormick, head of North American foreign exchange strategy at TD Securities, agreed that oil has been the driver of the Canadian dollar lately, saying “indeed, a 10 per cent rally in WTI is worth a 1.4 per cent move higher in Canadian dollar/U.S. dollar cross.”

But he added that it’s not enough to boost investment in Canada.

“The takeaway is that geopolitical tensions and supply drawdowns have benefited oil, but the Canadian dollar needs an upward sloping curve to spur economic investment and boost growth,” McCormick said in a note.

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