Canada is an interesting case study, given the surge in oil prices resulting from the war in the Middle East. The country is a major producer of crude oil, and crude accounts for about a fifth of its total exports. However, following the outbreak of hostilities in the Middle East, the Canadian dollar actually weakened. It only started to recover once it became clear that the US and Iran were looking to end the conflict.
Now that CADUSD has recovered to its pre-war level, the question is whether it will continue higher or resume sideways trending. Part of that answer can lie in interest rates, as the Fed is still seen on an easing track. However, a bump in inflation could push the BOC(Bank of Canada) to start hiking rates. Since interest rates in Canada are much lower than in the US, this would mean a narrowing of the rate gap. Under normal circumstances, that would be seen as a positive for the loonie, which is why traders are focusing on the upcoming Canadian CPI data.
How Oil Is Driving the CAD
Canada is in a unique position among major crude producers, despite being the world’s fifth-largest crude exporter. Almost all of it goes to the US, even if it is ultimately transhipped through the Gulf of America. Canada is extremely closely connected to the US economically, as over three-quarters of its exports go to its southern neighbour. As a result, Canada is more dependent on the US oil market than on the global energy market.
The US actually exports more oil than Canada, with the largest destination being the EU. In many cases, Canadian producers have long-term supply contracts with US buyers, which also help mitigate global price fluctuations. The initial market reaction to the war in the Middle East was to push Brent prices higher. US (and Canadian) supply was not impeded, so WTI was dragged higher by arbitrage. However, as the war progressed, refiners in Asia became increasingly worried about supply reliability, and have turned to buying from the US. Almost a hundred VLCCs (the largest crude carriers in the world that normally ply between the Persian Gulf and the Far East) are heading to the US to load up on crude.
What It Means for the Currency
With WTI above Brent as refiners try to secure supply, Canada could see an influx of funds. Many analysts believe that even if the Strait of Hormuz is reopened, it could take several months before confidence is restored, and shipping companies risk transit. Through the risk of being attacked by Iran being removed through an agreement, ship owners might be reluctant to head back into the Gulf and get trapped if tensions flare up. This could keep WTI elevated for months to come.
This will likely have a domestic impact, as higher WTI would mean increased prices at the pump in Canada, pushing up inflation. With interest rates significantly lower than in the US, the BOC(Bank of Canada) has more scope to raise rates, which could push the CAD higher.
What to Look Out For
The consensus is for March Canadian headlines CPI to jump to 2.5% from 1.8% prior. That would be well above the BOC’s 2.0% target. The core rate, however, is expected to increase only modestly, to 2.4% from 2.3%. Meanwhile, the BOC’s preferred inflation metric, the trimmed mean, is expected to split the difference, rising to 2.8% from 2.3% previously.
For now, the market is betting that BOC(Bank of Canada) will raise rates after July. At the last meeting, it said it would wait for data before assessing the outlook. A substantial bump up in inflation could bring forward expectations of a rate hike and support the CAD. But a miss would likely delay the chances of a rate hike, and weaken the currency.
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