Canadian Dollar Forecast to Underperform Despite Fast-Improving Oil Price Dynamics

The Canadian dollar exchange rate complex may have seen the underperformance that has characterised performance this May coming to an end.

• Oil price uptrend forecast to extend, seen as CAD supportive
• But strategists still see potential CAD weakness ahead, GBP/CAD and USD/CAD forecast higher

The Canadian dollar has under-performed the US dollar for two weeks now allowing the USD to CAD conversion the chance to push higher from 2016 lows at 1.2461 to the current range centred around 1.29’s.

The pound to Canadian dollar exchange rate has meanwhile bounced off the floor at 1.81 to recover to the mid 1.85s.

However, in both USD/CAD and GBP/CAD the charts betray an inability to push much higher; we are potentially witnessing the end of the recent bout of Canadian dollar weakness.

“CAD’s -0.2% return last week should be view as an outperformance. CAD reached a new high for the year against AUD. The CADMXN cross reached a new all-time high. The principal reason for CAD outperformance is presumably last week’s 2.8% rally in WTI,” says the head of FX at BMO Capital, Stephen Gallo.

WCS grade oil gained 5.0%, WTI and Brent ended the week at $46.33 and $49.3, respectively, increasing on a better than expected EIA STEO report. WTI rose 3.36% last week, while Brent was up 4.46%.

The WTI/Brent gap narrowed last week due to supply disruptions from the Canadian Wildfires, while militant activity in several African producing countries also contributed to output declines.

However, despite the oil gains, CAD still lost a bit of ground against the USD because interest rate differentials moved against it.

But, with forecasts for oil continuing to point to further advances we would imagine that any USD weakness will be jumped on.

“Technical indicators for crude are far superior now than they were a year ago, when WTI began its 'double dip' to sub-$30 levels. Brent has broken (and more importantly, held) the 50-week moving average and we believe crude prices could test the $58-$60/bbl band in the 3-6 month intermediate term,” says James West at Evercore ISI.

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The Oil Market Picture is Looking Very Different

It was a mere four months ago that the IEA was warning that the world might “drown in oil”, while the global oil balances published by all the main statistical agencies continued to show larger and larger amounts of excess supply accumulating in 2016, up until very recently.

The message for the oil market was clear: inventory levels, already at all-time highs, would likely continue to build aggressively all the way through to year-end, with only a gradual slowing in the rate of build in the second half of the year.

“However, that picture is now very different and the speed of the transition from what looked like a huge surplus just a short while ago to a market that is now rebalancing very quickly is quite remarkable,” says Kevin Norrish at Barclays in London.

For example, last month, the EIA’s implied global oil surplus for 2016 stood at a massive 514mn barrels, but that has now shrunk by a third, to a much more manageable 362mn barrels.

“The big shift that has caused this change is an improved outlook for demand after what appears to have been a very strong recovery following a weak start to the year, especially in January, when distillates demand was very soft, due partly to a warm US winter but also because of weakness in global manufacturing activity, which has subsequently improved,” says Norrish.

The most significant upward revisions to demand have been made in China, where the effect of the government stimulus package has improved what was a very weak picture for diesel demand.

“The oil market looks set on a course for rebalancing much faster than previously expected and for now at least, the risk of sharply lower prices would seem to depend on a macroeconomic speed bump or surprise,” says Norrish.

Technicals Still Suggest the CAD Could Decline Against Pound and Dollar

It must also be pointed out that it is too soon to suggest the Canadian dollar is about to turn higher based on technical observations of the underlying structural setup in the CAD market.

Short-term trend strength studies (DMI) support the stronger USD tone and Shaun Osborne, analyst at Scotiabank, thinks the USD should now push on to retest the 1.2990/00 area in fairly quick order.  

“New, short-term cycle highs above 1.3015 will add to the broader corrective move in the USD that got underway at the start of the month (via bullish intraday, daily and weekly reversal signals),” says Osborne. “We continue to target the  1.33/1.35 range as the corrective objective and advocate buying minor USD dips.”

Regarding the GBP to CAD exchange rate’s outlook, Osborne notes the picture remains potentially positive.

The “rounded low”, which formed through April and the minor, counter-trend dip in the GBP over the past week give the appearance of a classic “cup & handle” reversal formation.

The minor drift back in the market after the initial rally is typically followed by a more dynamic phase of (bullish) market movement.

“GBP dips have held the 40-day MA this week and we think the technical set up at least suggests the GBP rebound is likely to extend, says Osborne.