The loonie and oil, tied at the hip

Over the last couple of weeks,we have been asked our view on the Canadian dollar, as oil has come under pressure. In short, investors should understand that the Canadian dollar has recoupled to oil prices. As such, on the belief that oil prices are near their bottom, we believe the Canadian dollar vis-à-vis the US dollar is also near its bottom.

For the most part, over the last five years or so, movement in the Canadian dollar (CAD/USD) has been a function of oil prices and the difference in interest rates between Canada and the US— specifically, the 2-year yield. Recently, however, the loonie’s relationship to interest rates has completely broken down and the daily moves can be entirely attributed to the price of oil — specifically, the benchmark price per barrel for West Texas Intermediate crude. As oil prices have fallen sharply, so too has the Canadian dollar.

Just last week, we wrote about the tenuous situation in Canada and the economic reality of recession (“When a black swan runs into an oil spill”). In that note, we highlighted our low-end target for the loonie of US$0.695 on lower oil prices. We did not expect to hit that target in one week, but then again, given the volatility of the markets these days we shouldn’t be surprised. Oil is rebounding today from US$22/bbl yesterday to US$25/bbl at the time of writing. We wouldn’t take today’s direction that the low has been reached for oil prices. We have learned through multiple periods (i.e., failed calls) that trying to call oil prices is an exercise in futility, especially at a time when market participants — Russia and Saudi Arabia — are playing a game of attrition. However, it is worthwhile to get a sense of how low oil could go and what impact that might have for the loonie.

Given the new decade lows reached for oil yesterday, we have to go waaaay back to 2001 to find a time when crude was lower. Crude reached a low of US$17.45 in November 2001. If we use this price in our fair value model, the CAD could reach a low of US$0.6665 (CA$1.5004). And while the loonie is ignoring the rate environment for now, should the Bank of Canada cut rates to 0% — as we expect — based on our fair value model, it isn’t likely to put further downside pressure on the CADUSD. What our work would suggest is that while there may still be downside, we are likely much closer to the low for the Canadian dollar based on oil prices than some market participants believe.

The chart shows the three-month correlation of the CADUSD exchange rate compared to oil price as measured by West Texas Intermediate and spread between the US 2 year yield and the Canadian 2 year yield from 2016 to current. The magnitude of correlation of either oil or 2 year spread to the exchange rate varies over time. Recently however, the loonie’s relationship to interest rates has completely broken down and the daily moves can be almost entirely attributed to the price of oil.
The chart shows the price of oil, as measured by West Texas Intermediate, the Canadian Dollar/US Dollar exchange rate and our team’s fair value for the CAD/USD exchange rate based on oil prices from 1999 to current. As the price of oil fell toward $20/barrel, the exchange rate fell below $0.70 in line with what the fair value model would suggest.

Philip Petursson, CIM
Chief Investment Strategist

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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Philip Petursson

Philip Petursson, 

Chief Investment Strategist

Manulife Investment Management

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Kevin Headland

Kevin Headland, 

Senior Investment Strategist

Manulife Investment Management

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Macan Nia

Macan Nia, 

Senior Investment Strategist

Manulife Investment Management

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