As oil prices bounced back in the last few days, the CAD to USD exchange rate has climbed more than two cents. With West Texas Intermediate (WTI) crude surging as much as 8.5% on Friday to more than $32.00 a barrel, you might think that the Canadian dollar could also be on its way back up. However, if you take a look at what could affect the CAD/USD pair you’d see that the situation is not so rosy.
Sure, the Bank of Canada did not cut its benchmark interest rate on Wednesday, but that doesn’t mean it won’t do it in the future. And even if interest rates stay at the current level, the Canadian dollar still has more room to drop against the U.S. dollar.
Let me explain…
CAD USD: Oil Prices Facing Downward Pressure
First, let’s not forget that the CAD/USD exchange rate has strong ties to the price of oil. I mean, Canada is exporting 2.9 million barrels of crude oil to the U.S. each day. (Source: “Company Level Imports,” U.S. Energy Information Administration, December 31, 2015.)
Changes in oil prices almost always get reflected in the move of the currency pair. While this might look like a good thing for the loonie because oil prices just shot up big-time on Friday, remember that supply and demand fundamentals will eventually play out.
On the supply side, OPEC countries have not made any plans to cut back their production whatsoever. And although demand for oil tends to be inelastic in the short run, growth in the global economy is slowing down. That could translate to less demand for oil in the long-term.
With supply going strong and demand maybe weakening, oil prices could stay low or drop even further. This negative outlook for oil prices also suggests that a similar move could take place in the CAD to USD exchange rate.
Note that oil prices can affect the value of the loonie not only through Canada’s massive exports of the commodity, but also indirectly through the Canadian economy.
The oil and gas industry plays a significant role in Canada’s economy. Since the downfall in oil prices began in 2014, the industry has suffered substantial year-over-year declines in output, which was not good for Canada’s gross domestic product (GDP). Moreover, quite a few oil companies in Canada have had massive layoffs.
The point is that Canada’s economy has been hit hard. The U.S. economy, on the other hand, is in much better shape compared to its neighbor to the north. The labor market in the U.S. has been gaining solid jobs, with the unemployment rate staying at a seven-year low of five percent. Moreover, economic growth in the U.S. has picked up momentum, with real GDP growing at an annual rate of 3.9% in the second quarter of 2015 and an even two percent in the third quarter. (Source: “News Release: Gross Domestic Product,” Bureau of Economic Analysis, December 22, 2015.)
The economic recovery in the U.S. was going so well that the U.S. Federal Reserve decided to increase its benchmark interest rate last month, marking the first rate hike since the financial crisis. Moreover, the Fed is forecasting as many as four rate hikes in 2016.
Bank of Canada to Cut Rates Soon?
Canada’s central bank, on the other hand, has done the exact opposite. In an effort to stimulate the economy, the Bank of Canada lowered its benchmark interest rate twice in 2015. Although the Canadian central bank did not make a rate cut last week, it doesn’t mean it won’t do it in the future. In fact, analysts are saying that Canada might get a rate cut sooner rather than later.
According to David Madani, economist at Capital Economics, the Canadian economy “will be lucky to grow by one percent [this year]… Accordingly, we wouldn’t rule out another rate cut in March or April at the latest.” (Source: “Bank of Canada Holds Key Interest Rate Steady at 0.5%,” CBC News, January 20, 2016.)
To sum up, don’t be fooled by the dead cat bounce. The CAD to USD exchange rate could stay low for a very long time.