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Understanding the Drivers of Canadian Dollar Exchange Rate Movements

By Frances Coppola

Canada's open economy is an attractive destination for many international businesses. Canada is the U.S.'s largest trade partner, and is of growing importance for businesses in Europe and Asia. However, Canada's floating exchange rate exposes international businesses to FX risk. Understanding the principal drivers of the Canadian dollar's exchange rate movements may help businesses to devise effective FX risk management strategies for their import-export trade with Canada.

The Effect of Oil Prices on the Canadian Dollar Exchange Rate

 

Canada is the sixth-largest oil producer in the world,1 and has the third-biggest oil reserves.1 Crude oil exports currently make up 10 percent of its total exports by value, second only to automobile exports.3 However, because of the considerable fall in the global price of crude oil since 2014, this percentage has declined somewhat despite higher production.4 Nonetheless, oil remains a significant contributor to the Canadian economy. Oil production is projected to increase by 39 percent to 5.4 million barrels per day by 2030.5

 

Because oil exports are an important driver of the Canadian economy, the Canadian dollar (CAD) is sometimes called a "petrocurrency."6 The exchange rates of petrocurrencies tend to rise and fall with the international price of oil. In turn, because oil is priced in U.S. dollars (USD), the international oil price tends to fall as the USD's trade weighted exchange rate rises, and tends to rise as the USD exchange rate falls. The CAD's exchange rate therefore tends to rise versus USD when the international price of oil rises, and fall when it falls.7

 

After the 2008 financial crisis, the CAD-USD exchange rate rose significantly in parallel with oil prices. It remained strong until 2014, when the oil price started to fall. As the oil price slid in the "commodities unwind" of 2014-15, the CAD-USD exchange rate also dropped.8

 

But as oil exports diminished in value, and their percentage contribution to the Canadian economy consequently declined, the correlation between the CAD-USD exchange rate and the oil price started to weaken.9 By December 2016, some analysts were arguing that other economic factors were a more important driver of CAD-USD exchange rate movements than the oil price.10

 

However, the CAD-USD exchange rate continues to respond to movements in the oil price. In May 2017, for example, it fell along with the oil price when the oil producers' cartel OPEC failed to reach agreement on measures to prop up prices.11

 

Economic Influences on the Canadian Dollar Exchange Rate

 

Apart from oil price, the largest influence on the CAD-USD exchange rate is the U.S. economy, although other countries are also influential.12 Because Canada's economy is much smaller than the U.S., and a high proportion of Canada's trade is with the U.S., the CAD-USD exchange rate is highly sensitive to changes in U.S. monetary and fiscal policy. For example, experts said that the weakening CAD exchange rate in the last quarter of 2016 was due to a sharply rising USD, which in turn reflected market expectations that fiscal stimulus would result in higher inflation and hence higher U.S. interest rates. Instead of tracking the oil price, therefore, the CAD-USD exchange rate was tracking the expected path of U.S. interest rates.13

 

The Bank of Canada notes that higher interest rates in Canada would tend to raise the CAD-USD exchange rate: conversely, rising interest rates in the U.S. would tend to weaken the CAD.14 Thus, the Federal Reserve's cautious approach to interest increases has at times resulted in a stronger, not a weaker, CAD.15

 

Other factors that can influence the CAD-USD exchange rate include conditions of global financial markets: the Bank of Canada notes that the U.S. dollar's "safe haven" role means that when markets are turbulent, the U.S. dollar can rise against all currencies including the Canadian dollar, due to inflows of risk-averse capital to dollar-denominated investments.16 The trade balance between Canada and other countries also influences the CAD's exchange rate: trade surpluses tend to increase demand for the CAD, pushing up the exchange rate, while trade deficits tend to reduce demand, depressing the exchange rate.17

 

The Bank of Canada says that over the longer term, the oil price is the largest determinant of the Canadian dollar's exchange rate.18 It notes that the floating exchange rate helps to protect the Canadian economy from shocks caused by sudden changes in oil price dynamics. But the exchange rate is also influenced over the longer term by Canada's economic performance relative to its trade partners. The Bank of Canada's price stability mandate helps it to minimize unstable exchange rate movements due to domestic economic factors.19

 

The

Takeaway:

As the principal driver of the CAD-USD exchange rate is the oil price, businesses may wish to monitor developments in oil price dynamics as part of their FX risk management strategy. However, economic policy changes in both the U.S. and Canada also play a part, and CAD's exchange rate versus other trade partners is driven more by other economic factors. Businesses may wish to develop a "dashboard" of economic indicators to help them manage their Canadian dollar exposures effectively.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.

Sources

1. “Oil,” Canadian Association of Petroleum Producers; http://www.capp.ca/canadian-oil-and-natural-gas/oil
2. “Top 10 Countries with the World’s Biggest Oil Reserves,” Global European Anticipation Bulletin; http://geab.eu/en/top-10-countries-with-the-worlds-biggest-oil-reserves/
3. “Canada Exports, Imports and Trade Partners,” Observatory of Economic Complexity (MIT Media Lab); https://atlas.media.mit.edu/en/profile/country/can/
4. “2016 Oil Exports Statistics Summary,” National Energy Board of Canada; http://www.neb-one.gc.ca/nrg/sttstc/crdlndptrlmprdct/stt/crdlsmmr/2016/smmry2016-eng.html
5. “2017 Crude Oil Forecast, Markets and Transportation,” Canadian Association of Petroleum Producers; http://www.capp.ca/publications-and-statistics/crude-oil-forecast
6. “Is the Canadian dollar a petrocurrency?,” UBC News; https://news.ubc.ca/2015/04/16/is-the-canadian-dollar-a-petrocurrency/
7. “How and Why Oil Impacts the Canadian Dollar,” Investopedia; http://www.investopedia.com/articles/investing/021315/how-why-oil-impacts-canadian-dollar-cad.asp
8. “Is the Canadian dollar a petrocurrency?,” UBC News; https://news.ubc.ca/2015/04/16/is-the-canadian-dollar-a-petrocurrency/
9. “Canadian dollar correlation with oil prices is getting weaker,” Pound Sterling Live; https://www.poundsterlinglive.com/cad/5391-canadian-dollar-losing-correlation-with-black-gold-just-as-prices-rise-on-production-freeze-hopes
10. “Canadian dollar loses oil price focus, Trump trade takes all,” NASDAQ Daily FX; http://www.nasdaq.com/article/canadian-dollar-loses-crude-oil-price-focus-trump-trade-takes-all-cm724926
11. “OPEC Sends Oil And Canadian Dollar Lower,” Pound Sterling Live; https://www.poundsterlinglive.com/cad/6851-opec-decision-hurts-oil-and-canadian-dollar
12. Ibid.
13. “Canadian dollar loses oil price focus, Trump trade takes all,” NASDAQ Daily FX; http://www.nasdaq.com/article/canadian-dollar-loses-crude-oil-price-focus-trump-trade-takes-all-cm724926
14. “The Exchange Rate,” Bank of Canada; http://www.bankofcanada.ca/wp-content/uploads/2010/11/exchange_rate.pdf
15. “How the U.S. Federal Reserve rate hike might affect Canadians’ wallets,” Global News (Canada); https://globalnews.ca/news/3311667/how-the-u-s-federal-reserve-rate-hike-might-affect-canadians-wallets/
16. “The Exchange Rate,” Bank of Canada; http://www.bankofcanada.ca/wp-content/uploads/2010/11/exchange_rate.pdf
17. Ibid.
18. Ibid.
19. Ibid.

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