Canadian Dollar and Crude Oil Estranged, but Far From Divorced

Modified: Wednesday, 09 March 2022 12:42 GMT
Written by: James Skinner

CAD/Oil correlation near zero since Jan 2021
Soft capital spending, investment link at play
Falling prices could prompt increased hedging
Minor positive influence on CAD in short-term
But positive correlations could yet be revived

A single oil pump jack in the farm field. Calgary, Alberta, Canada. Image © Adobe Stock

Canada’s Dollar had slipped against the U.S. Dollar for 2022 by Wednesday even after a significant rally in oil prices but CIBC Capital Maarkets research suggests this relationship reflects more of a temporary estrangement than it does any kind of long-term or permanent divorce.

The Canadian Dollar had fallen by around half a percent against the U.S. Dollar for the year-to-date by the mid-week session despite a 60% increase in international oil prices as well as a 35% gain for Western Canada Select during the intervening period.

For the many in and around the markets who still view the Loonie as a “petrocurrency” that should rise with the price of oil this may have come as a shock, although CIBC’s research tells of a relationship that has been steadily changing over a number of years, leaving the currency misunderstood.

“Beyond what we’ve seen with our naked eyes in the steadiness of the C$ amidst volatile crude prices, there is indeed statistical evidence to support the weakening of the linkage between oil and Canada-US interest differentials, and the corresponding softening of the oil-C$ tie,” says Avery Shenfeld, chief economist at CIBC Capital Markets.

Above: CAD/USD shown at weekly intervals with WTI and Brent crude oils.

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Shenfeld and the CIBC team note prominently in their research that oil sector capital spending and investment had fallen from almost four percent of GDP in late 2013 to barely more than one percent in 2020 and 2021, even with the various significant increases in prices seen over that time.

This means that rising oil prices would have a lesser propensity to promote employment, household income growth and inflation, so are in turn likely to have a lesser influence on the Bank of Canada (BoC) interest rate outlook.

“Looking at the period since 2018, after capital spending in Canada’s energy sector had completed its retrenchment, the correlation completely vanishes (in fact, it’s slightly negative). The market no longer looks at oil prices as a factor in relative interest rates between the US and Canada,” Shenfeld says.

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“Looking only at the last year, it’s essentially disappeared, but we would argue that’s too short a window to conclude that oil will no longer matter at all for the loonie, particularly since the past year has entailed major swings in expectations for central bank policy for reasons that were much broader than what was happening to oil,” he adds.

However it may seem to financial market participants and observers, CIBC says the greatly reduced correlation between the Loonie and oil prices is a favourable development for domestic producers because it means their foreign currency earnings are less likely to be eaten up by rising and falling Canadian Dollar exchange rates.

“They can enjoy more of a climb in crude without seeing an offsetting appreciation of the Canadian dollar, but conversely, should crude oil retreat from recent heights, it won’t promote as much of a softening in the loonie as we would have seen in the past,” Shenfeld says.

Source: CIBC Capital Markets.

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This dynamic potentially reinforces the weakening correlation between oil prices and Loonie as it could already have led, and may yet perpetuate a reduction in the extent to which domestic oil producers hedge out the risk of rising exchange rates, which typically involves buying the Canadian Dollar.

Similarly, the reduced correlation could have a supportive influence on the Loonie during times when oil prices are falling and especially if there has been a change in hedging behaviour.

This would be because already-lower hedge ratios and falling oil prices could potentially lead to an increase in hedging-related Canadian Dollar demand.

“We continue to expect a modest weakening in the Canadian dollar over upcoming quarters but that has less to do with oil’s likely slippage than with monetary policy,” Shenfeld says.

“Neither the Ukraine conflict nor some upside surprises in inflation have seen us alter the 100 basis points we expect from both the Fed and the Bank of Canada this year, with a further leg in store for the subsequent two years,” he also said.