Canada – CAD Drivers & Oil Dependency

When the subject of commodity currencies arises among traders, it almost invariably refers to the Canadian dollar. The Canadian dollar, also referred to by its nickname the "loonie," is one of the most actively traded and widely used currencies in the world, and it is frequently said to be closely tied to oil prices.

However, while fluctuating prices within the energy market may be a defining attribute, the path of the loonie is more complex and nuanced. In reality, to determine why the value of the CAD is evolving in a particular direction, it is a function of the interaction of multiple drivers, including central bank interest rate decisions, domestic economic growth, global relative trade and capital flows, and changing risk appetite sentiment.

The purpose of this article is to review how we interpret the major underlying drivers of the Canadian dollar (CAD) and explain why oil has such a significant influence over the CAD, thereby facilitating traders and investors in their expected path with the CAD in relation to forex market movements.

Canadian Dollar in Context

The Canadian dollar is regarded as one of the most widely traded currencies globally. It is generally considered a proxy for the Canadian economy and goods trade (both domestic and inbound/outbound). It ultimately influences the interest currency to forecast in general economic and/or foreign exchange trades, particularly in broadly traded pairs, such as the highly liquid US/Canadian dollar pairs.

In terms of relative strength of the Canadian dollar against other currencies, the currency is a reflection of the Canadian economic screw, along with a proxy for the global demand for goods, based on its geographic proximity to central North America, western markets, and/or South America.

In summary, investors look to the Canadian dollar based on its exposure to Canada's natural resources. The US-Canada relationship is regarded as a stable political and financial regime that contributes to the country's geography, as well as its importing and exporting of goods.

Oil as the Real Primary Driver

Oil is the most critical driver for the CAD for apparent reasons, and that revolves around the fact that Canada is a significant energy exporter in the global market, and of all of the resources derived from whichever sector (i.e. ethnic, regional, etc.), oil is the basis of much of the Canadian export revenues of goods and services.

• Increasing oil prices: When oil prices rise, the Canadian dollar typically appreciates against other currencies, as the country's trade surplus expands and demand for its products increases, particularly among Chinese respondents.

• Decreasing oil prices: When oil prices decrease, the Canadian dollar generally weakens against other currencies, as revenue declines and demand for Canadian exports decreases. The connection is so strong that many traders refer to the CAD as a "petro-currency." In fact, it is essential to consider global oil benchmarks, such as WTI and Brent, when trading the CAD.

The Bank of Canada and Monetary Policy

The Bank of Canada (BoC) will also be a significant driver of CAD movements. Like many other major central banks, it is responsible for setting interest rates and managing inflation.

• Rate Hikes: Prolonged rate hikes generally strengthen CAD because they attract investors into the CAD market in search of higher yields.

• Rate Cuts: Rate cuts generally weaken CAD as investors look elsewhere for better returns.

• Policy Statements: Apparently, negligible changes in attitude and tone during BoC speeches can shift markets, tighten monetary policy, and subsequently produce direct CAD movements.

Wealth-sensitive data such as inflation levels, employment reports, and GDP trends all feed into BoC decisions; thereby, making BoC communication critical for currency traders.  

Canada's Economic Growth and Domestic Metrics

Canada has a resource-rich economy, but it is also very diverse with substantial finance, manufacturing, and technology sectors. Of course, data points associated with GDP growth, retail sales, and manufacturing metrics play into CAD movements.

Overall, better economic data typically lifts the CAD, as it signals a more positive outlook for Canada. In contrast, weaker economic data points may lower the CAD, particularly when they occur alongside falling commodity prices.

Trade Balance and Global Demand

Because Canada is a trading nation, it has a heavily weighted economy; thus, an increase in and/or a healthy trade balance supports CAD appreciation. Conversely, a deficit will undermine CAD appreciation. Since the U.S. is Canada's largest trading partner, the outlook and potential for growth of the US economy are reflected in CAD movements.

Subsequently, demand for commodities such as oil, lumber, and metals will continue to drive demand for Canadian exports. Consequently, changes in global growth — arising from China, Europe, or emerging markets – generally have an impact on the performance of CAD.

Inflation and Cost of Living

Inflation has a measurable effect on the Canadian economy and the BoC. Rising consumer price inflation typically leads the central bank to begin raising rates, which provides support to the CAD. Moderate inflation can be understood as a sign of healthy demand; however, enduring inflation can lead to uncertainty.

Importantly, the energy commodity component plays a significant role in measuring Canadian inflation, which links oil prices to the domestic purchasing power of Canadians and the country's export market.

Political and Fiscal Stability

Political stability in Canada is a net positive for CAD. A clear fiscal policy, manageable debt burden relative to other economies, and a stable banking system tend to instil confidence in the minds of external investors. Political debates over energy projects, trade policy, or fiscal spending sometimes create volatility.

Global Risk Sentiment

In addition to domestic factors, CAD tends to be highly susceptible to global market sentiment. In risk-on environments, where investors are optimistic about growth, CAD tends to appreciate and is then directly related to the demand for commodities. In risk-off environments, such as financial crises or geopolitical shocks, investors tend to flock to safe-haven currencies like the USD or JPY, which can lead to a depreciated CAD in such scenarios.

This makes CAD a double-edged sword: one that benefits from growth but loses value as soon as the fear dynamic comes into play.

Case studies

• Oil price crash 2014-2015: The CAD fell significantly alongside a drop in oil prices, demonstrating that it is dependent on energy markets.

• Pandemic shock (2020), oil demand collapsed, CAD weakened, but exploded as energy prices increased.

• BoC rate hiking cycle (2022): In response to inflation, the BOC raised rates aggressively to support CAD even as global uncertainty remained a drag on markets.

These examples demonstrate how a mix of oil, monetary policy and global conditions drives the loonie.

Takeaways for CAD Traders

1. Daily oil price tracking — oil price is still the most significant CAD driver.

2. Bank of Canada announcements and inflation reports watch for clues about their policy.

3. U.S. Data- A better US economy tends to help Canada.

4. Risk sentiment: CAD does great in risk on, struggles in risk off.

5. Use USD/CAD as a barometer. It's a blended US and Canadian dynamics.

Challenges in Trading CAD

While CAD often exhibits clear patterns, it can also throw in the occasional surprise. Correlations with oil, for example, can break down due to unexpected market noise, such as short-term influences or the occasional global shock. Additionally, market shifts in the US interest rates can mute Canadian fundamentals, as the relationship to USD/CAD is paramount in trading FX around the world.

Conclusion

The CAD is one of the more interesting currencies in the forex market, shaped by a combination of oil, central banking policies, economic fundamentals, and global risk sentiment. While oil remains the single most significant driver of its destiny, it represents only a portion of the loonie's success. GDP growth, inflation, trade balance and risk appetite must all be considered.

Traders and investors who are going to be successful in guessing the CAD must look at both domestic and international perspectives, implying the importance of tracking daily oil movement, following the Bank of Canada closely, along with looking for cues about global risk sentiment, as well as measuring economic success using predominantly US economic metrics.

In an interconnected market space, the Canadian dollar tells a unique story of resources, robust resource management, and international connections, and those who follow that story can find opportunities.