Oil Prices and Their Relationship with USD/CAD & Other Pairs

Have you ever thought that it seems like when Oil rises, the Canadian dollar responds, or is it perhaps the fact that when there are shifts or instability in Energy markets, the other currency pair seems to change direction? If so, it's not by chance.

Oil, in specific ways, can be a silent influencer for many foreign exchange currency movements. In the rest of this article, we will break down how the Oil price changes process through with USD/CAD and beyond, and provide a more straightforward pathway for viewing dynamics in major currency movements.

Why is Oil Important in Currency Movements

Oil is more than a commodity; it is an integral part of the global economy's structure. Since various currencies, specifically from oil-exporting nations, tend to be included in energy trade, Oil price movements can have substantial feedback loops through trade balance, national income, and investor confidence. In currency markets, these feedback loops take the form of currency strengths or weaknesses surrounding important "petrocurrencies" closely tied to the Oil trade.

The USD/CAD Relationship: A Unique Context

The Canadian Dollar as a Petrocurrency

Canada is a major Oil exporter to the world, and the success of Oil sales plays a significant role in foreign exchange revenue for the Canadian economy. Therefore, when Oil prices move higher, trade revenue generally increases for Canada, resulting in a strengthening of the CAD relative to the USD. Conversely, Oil prices decrease, which will decrease Canadian Export revenue and weaken the CAD.

Mechanism at Play

When the price of Oil is higher, Canadian exporters receive more USD per barrel. For oil companies in Canada, selling x barrels of Oil to the US results in a higher return than if the price were lower. As a result, an influx of USD in Canada increases the supply (for each CAD exchanged) or, ultimately, changes USD/CAD to a lower value (i.e., each USD buys fewer CAD). Whenever oil prices decline, that flow tightens, and the Canadian Dollar-US Dollar currency pair may increase in value.

Real-World Examples

It is essential to recognise that the Canadian Dollar-US Dollar currency pair, to some extent, measures the inverse values of oil prices, and a USD/CAD increase is a likely reaction to a sharp decline in oil prices. In other words, crude oil or Brent future prices moving higher generally coincides with a stronger Canadian Dollar and a lower USD/CAD. On the other hand, when oil prices fall, it is common (though not guaranteed) for the Canadian Dollar to weaken against the US Dollar, increasing the value of USD/CAD. However, the directionality of oil prices and USD/CAD is not guaranteed – influencing factors such as interest rates, central bank policy, and global risk sentiment can alter that relationship.

Implications Beyond USD/CAD: Oil Prices and Other Currency Pairs

CAD Crosses (ex., EURCAD, GBPCAD)

Because the Canadian Dollar can be sensitive to oil prices, FX pairs that are CAD crosses indirectly reflect the CAD's relationship to oil prices. For example, when oil prices sharply increase, CAD can rally. As a result, CAD crosses such as EURCAD and GBPCAD generally move lower while the CAD appreciates against the counterpart currency.

Emerging Market & Commodity Currencies

Finally, depending on the degree of attachment to Oil, certain emerging market currencies (i.e., RUB, NGN, or MXN) may be influenced by oil prices. However, a sustained rally in Oil supports a currency in a similar or energy-related currency pair with regard to the USD.

USD vs. Commodity Importers

In countries that rely heavily on imports, increases in Oil prices will often lead to higher import bills and costs,, which put even more pressure on the respective currency as oil prices rise, thereby deteriorating the currency'scurrency's potential and capacity compared to the USD.

What Drives the Relationship Between Oil and Forex?

Trade Balance / Current Account Effects

Oil price increases lead to increased earnings on exports (for exporters) and/or reduce the trade balance or the impact of oil price increases on the trade balance for oil importers. In both cases, the domestic currency strengthens. For oil importers, oil price increases will deteriorate the country's current account position, thus weakening their local currency.

Risk sentiment and market behaviour

Oil is often referred to as a gauge of global risk appetite. A rising oil price signals strong demand and/or an increase in demand. By contrast, a falling oil price indicates risk aversion through weak demand, inflation, or anticipation of recession. This risk sentiment can be easily translated into the currency market, influencing factors such as safe-haven flows, speculative positioning, and capital flows.

Interest rates and monetary policy

Central banks respond to inflationary pressures and the economic conditions they perceive. If oil prices are increasing at the same time inflation is rising, central banks may tighten their policies, which can impact yields, capital flows, and other factors. The change in yields or rate levels can also amplify or mute the effect of oil prices on currencies.

Supply-side shocks structure changes

Supply shocks (i.e. geopolitical strife, OPEC dynamics, natural disasters, etc.) can result in rapid movements in oil prices. Longer-term price behaviours in currencies can also begin to react to structural changes such as oil price shocks, relative to energy-price transitions, or technological improvements.

Practical Applications for Traders & Analysts

Use Oil as a Confirming Signal

Instead of seeking oil price signals, use Oil to confirm the potential setup of your forex trade. If you are bullish CAD vs USD based on fundamentals, a backdrop of rising oil prices gives you increased confidence in your trade. Conversely, if Oil is weak, you may step back or reduce potential risk.

Consider the relationship over time.

Relationships can change over time. What was once a valuable relationship, sustained over extended periods, may be considerably different depending on the stage of the monetary cycle or the time of the relationship. Regularly observe correlation metrics or track market movements.

Risk Management & Position Sizing

Because oil-driven moves sometimes reverse suddenly (for example, due to supply surprises), it is advisable to have stops in place and position size to control risk. It is also important not to overexpose yourself to Oil.

Use Multi-Factor Analysis

Consider oil trends in conjunction with interest rate differentials, price action technical setups, macroeconomic overlays, sentiment metrics, and other relevant factors. When you employ a more global analysis/manner, it tends to be more accurate and safer.

Examples Scenarios

• Scenario 1 – Oil Rally & CAD Bull Case:

If a positive development in global demand expectations and oil rallies by 15%, then the CAD will likely appreciate sharply and experience relative USD depreciation. In essence, USD/CAD could fall from 1.3400 to 1.3100. In this case, someone who is long CAD pairs and probably short USD/CAD is in business.

• Scenario 2 – Oil Crash & USD Bull Case:

If Oil crashes dramatically due to a 'supply dump' or a significant demand shock, as we just saw, the Canadian government will see its revenue collapse. Thus, the USD/CAD will likely surge significantly higher. Traders will likely trade a stronger USUSD case until stability occurs, rather than trading CAD weakness.

• Scenario 3 – Rate Hike in Oil Bull Case:

If Oil rallies higher, but the central banks (such as the Canadian or US central bank) are hiking rates significantly, the interest rate argument would entirely overshadow the oil movement. The contribution of Oil could be anything from minor to reverse, depending on yield spreads.

Challenges & Limitations

• Correlation break: At times, Oil and USD/CAD (or any pair) will decouple from one another. Each time oil does this, it could mean a more significant volatility or decoupling regime change.

• Lag effect: Currency markets may lag oil markets. What a trader may think and expect to happen based on Oil might be totally different or totally delayed.

• Confounding variables: Interest rates, global capital flows, trade data, global geopolitical news, etc. – each of these could either completely overwhelm or be completely insignificant on the oil impact.

• Over-reliance risk: If someone is legitimately trading around oil expectation alone or without broader confirmation, they are over-reliant on Oil.

summary

Oil has a strong and predictable impact on USD/CAD and other currency pairs, where associated gains and losses are tied to commodity export revenue. The impact will still come down to trade flows, revenue-generating associations, and generally market psychology.

But Oil will almost always not be the only piece of the puzzle. Interest rate, monetary policy, global risk perception, or supply shocks could all equally impact Oil, along with (or) against.

For practical purposes, the most helpful way for traders and analysts to utilise Oil is essentially a layering process for the oil/forex relationship, or to anticipate price movements. Use Oil to either confirm a basic profiling direction or broader position or bias, but also remain flexible to change.

If you do this with a disciplined risk process around Oil, ongoing rechecking of oil/forex, and a multi-factor framework, the oil price/forex correlation could be a valuable component of your analytical setups.