Forex Investment and Currency Trading

• The interrelationship between CAD, USD and oil is clearly evident through the impact of oil on trade balances. Presently, developments that are bullish for oil prices are bearish USD/CAD.
• However, the rally in oil prices (44% YTD) and by extension overall energy prices obscured that Canadian and US non-energy trade balances are behaving as one would expect given lengthy periods of CAD strength and USD weakness. This will prove to be USD/CAD bullish in the medium-term.

Fed Chairman Bernanke’s comment this week about the upside risk to US inflation from USD weakness sparked a USD rally, and sharp sell offs in oil and CAD. Even so, tight short-term oil supply/demand dynamics might limit the decline in oil prices, and there won’t soon be any inflation-psychology breaking relief at the gas pump for Americans. However, his comments do reinforce the link between USD, CAD and oil through US and Canadian trade balances. In particular, elevated oil prices over the past few months have kept the overall US trade deficit and the Canadian trade surplus elevated. Through the impact on trade, oil price strength would pose a bearish USD/CAD risk in the short-term preventing a clear break away from parity. However, in the medium term, the powerful bullish USD/CAD trade undercurrents are going to become increasingly evident toward supporting a call for USD/CAD to rally toward 1.10.

Short-Term: A Bearish USD/CAD Risk Through Trade
Canada’s trade surplus increased to C$5.3bn in March (cons: C$4.5bn) and the Q1 current account almost doubled expectations at C$5.6bn (cons: C$2.9bn). And that was with oil prices at US$110/b and natural gas prices at US$10/mmbtu. With oil prices tipping the scales at US$135/b through the end of May and with natural gas prices going along for the ride Canada’s (a net energy exporter) trade surplus will remain elevated well into Q2.

Meantime, the opposite scenario is unfolding in the net oil importing US. The surge in oil prices is propping up the trade deficit. Although the US petroleum trade deficit dipped to US$36bn in March, the subsequent surge in oil prices likely provided a strong upward thrust to that deficit deep into Q2. Hence, elevated oil prices will reinforce Canada’s trade surplus in coming months, and potentially sharply boost the US trade deficit. This could well help maintain a bearish bias to USD/CAD short of a sharp decline in oil prices that
weighs on the energy complex.

Medium Term: Bullish USD/CAD Factor
However, the oil price impact on trade is obscuring powerful dynamics that will prove to be medium term USD/CAD bullish. For example, despite contributing 2.0% to Canadian GDP growth in Q1, trade has been a persistent headwind to Canadian GDP growth since 2003. Market expects trade to remain a headwind to GDP through 2009. Trade is also a key concern for the BoC, and helps explain its eagerness to unleash the second most aggressive rate cut campaign after the Fed among the major central banks. Trade will continue to weigh on BoC rate deliberations in coming months, even as they leave rates unchanged after an expected 25bp rate cut on Tuesday. Moreover, while the nominal Canadian trade surplus is 2.1% of GDP in Q1, in real terms the Canadian trade deficit is near 7% of GDP. By comparison, the US trade deficit peaked at 6.8% of GDP in real terms in Q4 2005, hitting a trough fully three years into a USD bear market. As CAD only peaked in November 2007, it is highly probable that the real trade deficit won’t trough for several quarters. The nominal trade surplus will find it increasingly difficult to withstand the powerful underlying USD/CAD bullish transformation in trade volumes.
Oil prices are obscuring the underlying dynamic impact of trade adjustments on the US and Canadian economy, but eventually, the medium-term USD/CAD bullishness will dominate. Even so, should oil prices remain elevated for an extended period, possibly reflecting a tighter demand/supply balance, the upside for USD/CAD could prove more limited than expected. As in such a scenario, an oil sensitive relatively low inflation risk currency (that would be CAD) might prove to be somewhat of a safe harbour through periods
of increased uncertainty.