Canada Benefits from Prospect of $100 Oil

Trading USD/CAD these days has become synonymous with trading oil. The fate of oil and USD/CAD are intermingled because the Canada is the world’s second largest holder of oil reserves and the US’ most significant oil supplier. Unbeknownst to many, the size of their oil reserves is second only to Saudi Arabia. The geographical proximity between the US and Canada as well as the growing political uncertainty in the Middle East, Africa and South America makes Canada the preferred importer of oil to the US. Canada also remains one of the few places where multinational firms can access strategically important oil reserves. As indicated by the chart below, this correlation has lasted for years.

The Impact of a US Slowdown

The latest move in the Canadian dollar has befuddled many investors because the Canadian economy has traditionally been very sensitive to US economic growth. It is estimated that Canada exports 80 percent of their goods to the US, which makes it logical to assume that a slowdown in US demand would translate into a slowdown in Canadian exports. However over the past few years, Canada has become less reliant on US demand as the country’s vast oil resources begin to attract the attention of resource hungry countries like China.
Since Canada discovered a new source of oil after the reclassification of their Alberta oil sands to the economically recoverable category, their geopolitically turmoil free status has made them a very attractive provider of oil. Also, over the next 3 years, China’s oil import needs are expected to double and match that of the US by 2030. With little oil resources of their own, China has become a major buyer of oil on the global markets. This has helped the Canadian economy become more immune to the economic stability which may be part of the reason why Canadian data has been consistently surprising to the upside while US economic data has seen nothing but back to back disappointments. In the month of August, when the subprime crisis began to unfold, IVEY PMI actually jumped from 54.6 to 58.5, indicating increased manufacturing activity. During the same month the US lost 4k jobs while Canada added 23.3k. Manufacturing shipments continue to remain strong while net foreign purchases of Canadian securities increased for the first time in 3 months. This will keep the Bank of Canada on hold for the remainder of the year, which comes in stark contrast to the US Federal Reserve who is expected to lower interest rates by as much as 75bp this year.

USD/CAD: Zoning in on Parity

The Canadian dollar has been on a tear. In the past six months, the currency has made new 30 year highs after appreciating over 12 percent against the US dollar, putting parity within reach. At the beginning of the year, an exchange rate of 1.0 for USD/CAD seemed like a far fetched target, but now it has become a realistic and very probable one. Even though sentiment has become very one-sided and technicals indicate that the currency pair is extremely oversold, there is no major support until parity. With the risk of a global slowdown, record high oil prices and a resilient economy is behind the strength of the Loonie.

Dollar Broke 1.39 vs Euro

The dollar broke the 1.39 handle against the euro on Wednesday on raising concerns about US economy and the Fed outlook. The sterling rose to as high as 2.03 versus the dollar.The market focus has shifted from general risks aversion to US-economy related risk aversion. Last Friday¡¯s unexpectedly weak non-farm payrolls added to the worries about the US economy. It is still hard to measure how much impact the subprime and credit market crunch may have on the broad economy. The Fed needs to cut interest rates to avoid economic recession. The market has fully priced in an interest rate cut by the Fed on September 18 meeting. Most in the market has a bearish sentiment over the greenback

FX Awaits Data

At 4:00 AM Germany August WPI m/m (exp n/f, prev 0.4%)Germany August WPI y/y (exp n/f, prev 2.6%)At 4:30 AM UK July Trade Balance (exp –6.4 bln stg, prev –6.3 bln stg)At 8:15 AM` Canada August Housing Starts (exp 220k units, prev 215.6k units)At 8:30 AM Canada July New Housing Price Index (exp 0.6%, prev 0.7%)US July Trade Deficit (exp $59 bln, prev 58.14 bln)Canada July Trade Surplus (exp C$5.0 bln, prev C$ 5.3 bln)The currency market remains biased for a softer dollar amid a dearth of US economic data at the start of the week – with commentary from Federal Reserve members garnering the lion’s share of traders’ attention. Ahead of the blackout period before next week’s FOMC meeting, a barrage of comments from Fed speakers revealed mixed sentiment among its members providing little insight into the coming deliberations. However, market participants are largely anticipating a 25-basis point cut in the Fed funds rate with some even calling for a preemptive 50-basis point reduction to jumpstart the economy and stave off potential recession. Earlier in the session, Fed governor Mishkin sounded a dovish tone in his commentary, saying that risks to the inflation outlook is now more balanced given the greater downside risks to growth. He added that the Fed must remain vigilant on inflation, but it also needs to be attentive to keeping demand from falling beneath supply as well. His comments echo a similar tone to Lockhart’s and Yellen’s, who both suggested that policy should incorporate the recent downturn in US economic fundamentals. Lockhart said the recent payrolls number is very important and must be taken very seriously. Moreover, he said another key piece of economic data that will play a particularly key role in policy deliberations is consumer-spending data. This week’s retail sales report on Friday will bear additional significance since it will be the last piece of key data before the Fed’s meeting. Furthermore, Fed Chairman Bernanke’s comments on Tuesday will be closely scrutinized, who is scheduled to speak at the Bundesbank at 11:00 am.

In the U.S., inflation remains a priority

In effect, in the United States, inflation remains a menace, although oil just moved away from recent highs, and productivity is slowing, but is overall strong. In the second quarter of the year, non-farm business productivity rose 1.8% annualized, up from the 0.7% gain registered in the first quarter, but below the expected 2% rise. Unit labor costs, an indicator of inflationary trends, increased instead 2.1% from April to June, following a 3% move in the first quarter, previously reported at 1.8%. In the first six months of the year, they were up 4.5% from a year ago, the strongest move since the third quarter of 2000. Compensations are nonetheless improving. Non-farm sector hourly compensation increased 3.9% in the second quarter, compared to the jumped of 3.7% shown in the first quarter, but it declined 2% when adjusted for inflation. With inflation pushing higher, the Federal Reserve decision to leave rates unchanged at 5.25% was not a surprise. In the conclusive speech, the committee anticipated a milder growth and still sees inflation as the predominant concern. Risk to the economic activity in the U.S. is increasing due to housing, financial instability and credit tightening. In a few words, the Fed has left the door open for another intervention by the end of 2007, if economic conditions will be favourable.

The Federal Reserve ready to act

In reality, the consequences of the debacle must still be fully understood, but recent 50 basis points reduction in the discount rate to 5.75% gave some breath to the markets. Expectations are now for a rate cut by the Federal Reserve in the coming meetings. Will it happen? The Fed will give a serious look at next weeks/months markets behaviour and will be ready to act, if the decline of the indexes would not moderate. But the decision is not going to be painless, considering that inflation is far from being subdue.