Crude Oil (WTI) and the Loonie

We realize that after all these years looking at the market, our approach to currencies and global macro has remained quite simple and cyclical. We usually start our day by looking at the USDJPY (and AUDJPY), USDCNH and CSI 300 index charts that [kind of] describe us the overnight session. If we see huge moves in those charts, we know something important has happened in the ‘Est’ during the night that must be read and understood.

Since the beginning of this commodity meltdown (that analysts named ‘The End of the Super-Cycle’), each [bad] news coming from giant China usually had an impact on commodity prices, bringing down commodity currencies and especially the dollar-bloc ones (CAD, AUD and NZD). In today’s article, we focus on the Canadian Dollar (CAD or Loonie) and how it has reacted to the Oil prices decline over the past year. Since the beginning of 2014, USDCAD (orange line) has appreciated by 33% as the Canadian dollar has been dramatically impacted by the falling prices of oil (WTI, white line) now trading at $32.80 per bbl.

However, as you can see it on the chart below, even though the two underlying assets have been moving ‘together’ [most of the time] over the past year (i.e. lower oil prices implies CAD depreciation versus the US Dollar), the correlation can change over time. For instance, the 5-day correlation between USD and WTI stands now at -90.18%, but have also higher and even positive during small periods of time (mid-January or early December last year).


(Source: Bloomberg)

The reason why we like to watch correlation between assets classes is for the risk management and FX and commodity positioning. We have to admit that since the Fed started to consider shifting towards a tightening monetary policy cycle (i.e. raising interest rates), correlations have been much stronger and being diversified (i.e. not too much exposure to the US Dollar) can be difficult sometimes.

Quick thoughts ahead of the Fed’s minutes…

Last month (October 8th), while many investors were quite confident on the US Dollar strength momentum, the minutes of the FOMC’s September 16-17 policy meeting clearly showed us a message from US policymakers.

If you ask me if we see a stronger dollar in the LT against most of the currencies, we would answer yes and without any doubt. we think the Fed is comfortable with a Dollar appreciation, however we strongly believe they want the process to be slow and gradual. Despite strong recent fundamentals (another NFP above the 200K level in October for the 9th consecutive time, an annual 3.5% first Q3 GDP estimate, ISM Manufacturing PMI still above 50, Housing Start fluctuating around 1mio for the past year…), global economic issues will weigh on US policymakers this time.

Let’s start with the first issue: the decline in oil prices. December Crude Oil WTI futures contract (CLZ14) is down $30 since end-of-June’s high, now trading below the $75 level. While we mentioned in one of our previous article that the decline in oil prices will be problematic for a lot of OPEC countries (see article Oil Breakeven Prices), it is now entering into critical levels even for the US. We heard and read that low oil prices could be seen as a stimulus for consumers, however it is now at levels hurting US shale production. According to some experts, most shale oil fields breakeven is seen between $70 and $75 per barrel (see chart below from Barclays Research).


(Source: Barclays)

 As a reminder, the US, now producing around 8.5 million barrels per day (8.65mio in August 2014 according to the Energy Information Administration), was expected to surpass Russia within the next 10 years and grow its production by 35% to approximately 11.5mio barrels per day (see chart below from the Wall Street Journal).


(Source: Wall Street Journal)

Therefore, if prices continue to fell, the party could end earlier than expected. In addition, lower oil prices will add pressure on inflation expectations and the 2-percent target that the Fed is watching desperately. Important figure to watch tomorrow, CPI inflation is expected to remain steady at 1.7% in November. Any print below that would create a bit of US Dollar weakness as traders will start to lose credibility on the quantitative definition of ‘considerable time’.

Speaking of disinflationary pressures, let me go to the second issue: Dollar strength. Back in the minutes, Fed officials mentioned that they saw ‘rising dollar as a risk to exports and growth’. At that time, the USD index was trading at a 4-year high above the 86 level, and up 8.5% approximately since July low of 79.78. Today, the index is trading at even higher levels (87.60), thanks to the BoJ and the Yen development and EM meltdown. We saw that September US trade balance printed its biggest deficit since April at $43bn (vs. $40.2bn consensus), up from $40bn the previous month, due to a decline in exports (down 1.5%). In our opinion, ‘Dollar strength’ will be one of the topics tonight, therefore we could see some dollar weakness after the release. In addition, Dollar strength will also weigh on inflation expectations in the US (we don’t think the inflation effect of dollar appreciation is negligible, especially couple with lower oil prices).

Therefore, we see a bit of disappointment this evening, and we will encourage some of the US Dollar bulls to cut some of their long positions. The Euro and especially the British pound could recover from their recent losses, technical resistances are seen at 1.2670 and 1.5800 respectively.