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Why is Canadian Dollar Rising when Compared to US Dollar?

Candain dollar vs USD vs INR comparison

The Canadian dollar soared on the wings of widespread U.S. dollar selling against the major G-10 currencies yesterday. That rally took a breather overnight. USD/CAD traded at $1.2825 in Asia and $1.2709 in New York on Thursday, then rallied to $1.2774 overnight.

As has been the case lately, the USD/CAD price action was directed by global risk sentiment. That sentiment turned negative after a rash of bad news. Traders are disappointed due to the U.S. government’s failure to enact a stimulus bill to provide additional COVID-19 Relief to Americans.

The issue is exacerbated by the high numbers of new coronavirus cases across America. There were more than 219,000 COVID-19 cases reported yesterday.

News that the U.S. Food and Drug Administration endorsed Pfizer’s vaccine is positive, but not really helpful to the infected people.

Risk sentiment was also cautious after Asia equity indexes traded negatively, and many European bourses were down close to 1.0%. Gold prices fell and crude prices retreated from their peak levels.

GBP/USD dropped like a stone following very disappointing Brexit headlines. European Union Commission President Ursula von der Leyden reportedly told E.U. Commission members that a "No-deal" Brexit was the most likely outcome. U.K. Prime Minister Boris Johnson echoed her words. GBP/USD plunged from $1.3323 to $1.3136 in Toronto.

The GBP/USD plunge fueled elevated negative risk sentiment and knocked the Canadian dollar and the other commodity bloc currencies lower. 

EUR/USD traded with a negative bias in a $1.2111-$1.2162 range. Prices continue to be supported by EUR/GBP demand and yesterday’s European Central Bank actions.

The European Central Bank delivered as expected, and then some. Interest rates were left unchanged and the Pandemic Emergency Purchase Program (PEPP) was increased by €500 billion and extended six months. The bank cut its inflation forecast for 2020 to 0.2% from 0.3%, but the 2021 forecast remained at 1.0%. Growth forecasts were reduced as well, with 2021 predicted at 3.9% compared to 5.0% previously.

ECB President Christine Lagarde tried a bit of verbal currency intervention. She replied to a question saying "We do not target the exchange rate, but clearly exchange rates and particularly the appreciation of the euro play an important role and exercise downward pressure on prices. So we will monitor it, we will continue to monitor it very carefully going forward."

Canada’s Ivey PMI dipped to 52.7 points in November, down from 54.5 beforehand. The index has remained in expansionary territory since June, with readings above the neutral 50-level. The BoC delivered a message of “more of the same” at its monthly policy meeting. The bank kept rates at 0.25% and made no change to QE. Bank members hinted that rates would remain in ultra-low territory until the economy picked up. This stance means that we could see these rate levels for the next 2-3 years.

In the US, headline and core inflation both rose slightly, from 0.0% to 0.2%. PPI was also weak, with the headlined and core releases coming in at a negligible 0.1%. Unemployment claims surged to 853 thousand last week, up from 712 thousand. This points to weakness in the labor market, as the economy continues to struggle. The week wrapped up on a positive note, as UoM Consumer Sentiment improved to 81.4 in December, up from 77.0 beforehand.

The Canadian dollar, aka “the loonie” (the loon appears on the 1 dollar coin) is a commodity currency. Oil is Canada’s primary exports and fluctuations in the “black gold” move CAD as well. The C$ also moves with also with stocks, as it is considered a “risk currency”. However, CAD  also depends heavily on demand from its No. 1 trading partner and southern neighbor, the USA. Trump’s trade wars hurt CAD. NAFTA renegotiations are not going anywhere fast.

Dollar/CAD tends to react relatively slowly to important economic data from Canada. Retail traders thus have a better level playing field that can jump into a trade even without the most sophisticated algorithmic tools. Even the Canadian jobs report tends to result in a relatively long move

The Bank of Canada raised rates in two consecutive meetings, pushing the currency higher. However, this short cycle came to screeching halt alongside a slowdown in the economy and worries about inflation.

From the post-hike lows at the 1.20 handle, the pair began a correction phase and topped 1.29. However, the rise in oil prices due to some shortages and some profit taking stabilized the loonie. Another factor to watch is the housing situation in Toronto, Vancouver, and Montreal, which is worrying.

Canadian rate hikes, US demand and the price of oil will continue guiding USD/CAD.

The Canadian dollar is set to extend its rally over the coming year if the COVID-19 crisis becomes less of a drag on the global economy, FX strategists said, adding that a Democratic sweep in the U.S. election would bolster prospects for the currency.

The loonie has rallied nearly 11% against its U.S. counterpart since March, but progress has stalled over the last two months as resurging coronavirus cases and delay of a U.S. pandemic relief package weighed on investor sentiment.

Canada is a major producer of commodities, including oil, so the loonie tends to be sensitive to the outlook for the global economy. That outlook has become more uncertain in recent weeks as some countries, including Canada, reintroduced measures to help contain the spread of the virus.

What is USD/CAD?

USD/CAD is the abbreviation for the U.S. dollar versus Canadian dollar (USD/CAD) currency pair. The quote given for the USD/CAD currency pair tells the reader how many Canadian dollars (the quote currency) are needed to purchase one U.S. dollar (the base currency). Trading the USD/CAD currency pair is also known as trading the "loonie," which is the name for the Canadian one dollar coin. 

Understanding USD/CAD

The value of the USD/CAD pair is quoted as 1 U.S. dollar per X Canadian dollars. For example, if the pair is trading at 1.20 it means that it takes 1.2 Canadian dollars to buy 1 U.S. dollar. Although the USD/CAD currency pair has reached parity at different points in history, the U.S. dollar has traditionally been the stronger of the two currencies. The USD/CAD currency pair is quite actively traded as there are significant business ties between the two nations.

Factors that Affect the USD/CAD Currency Pair

The USD/CAD is affected by factors that influence the value of the U.S. dollar and/or the Canadian dollar in relation to each other and other currencies. For this reason, the interest rate differential between the Federal Reserve (Fed) and the Bank of Canada, will affect the value of these currencies when compared to each other. When the Fed intervenes in open market activities to make the U.S. dollar stronger, for example, the value of the USD/CAD cross will increase because it will take more Canadian dollars to purchase the stronger U.S dollar.

The value of the Canadian dollar is also highly correlated with the price of commodities, especially oil. Because the Canadian economy is heavily reliant on oil, the price of oil dictates the health of the economy and the currency itself. For this reason, the Canadian dollar is often labelled as a commodity currency.

USD/CAD and Parity

As mentioned, the USD/CAD pair has seen its traditional relationship hit price parity. For example, in the aftermath of the Great Recession and the subsequent quantitative easing from the U.S. Federal Reserve, the Canadian dollar soared against the U.S. dollar to trade below parity, eventually reaching 0.95. In fact, almost all of the instances of parity have been related to periods of U.S. financial difficulty or high oil prices - sometimes both. In 2016, however, oil prices slumped to decade-lows, trading below $30 a barrel. Consequently, the Canadian dollar hit a record low, trading to 1.46. This meant it required 1.46 Canadian dollars to buy 1 U.S. dollar.

Why is it rising?

Over the past 40 years, the value of the Canadian dollar (CAD) against the U.S. dollar (USD) has fluctuated significantly, at times rising nearly 10% or falling by as much as 37%. CAD is currently near the lower end of its historic range, worth about 76 U.S. cents. That, however, is more than 10% above its recent low set in March, when it was worth only 69 U.S. cents.

CAD’s value versus USD is nearly impossible to explain based on traditional macroeconomic data. Both countries had a coronavirus-related spike in unemployment, which is now subsiding. Canada and the U.S. have both seen decades of low, stable inflation. Both central banks have set interest rates close to zero. The interest rate differential, measured from CADUSD futures versus the spot currency, has averaged 6 basis points annualized for the past several months.

One difference between the U.S. and Canada is that while the U.S. Federal Reserve engaged in three rounds of quantitative easing (QE) between 2009 and 2014, the Bank of Canada (BOC) refrained from asset purchases until after the pandemic struck. It recently joined the QE club, and with gusto.

Despite Bank of Canada’s first-ever foray into QE, it has a much smaller balance sheet than its peers relative to size of its economy (27.3% of Canadian GDP versus 33.5% of US GDP for the Fed, 35.5% of UK GDP for the Bank of England, 54.7% of eurozone GDP for the European Central Bank and 125.1% of Japan’s GDP for the Bank of Japan).

That said, relative to the size of its economy, the Bank of Canada engaged in a bigger QE than any other central bank since the end of March (+22.1% of GDP).

The relationship between CADUSD and QE is a curious and counterintuitive one. Expectations might have been that that between 2009 and 2014, as the Fed expanded its balance sheet while the BOC did not, the U.S. dollar should have weakened versus CAD. The opposite occurred. From 2009 to 2014, with the Fed creating dollars to buy mostly U.S. Treasuries and some AAA-rated mortgage debt, USD strengthened versus CAD.

In any case, BOC’s large post-pandemic round of QE, which narrowed the gap between the relative size of the two central bank balance sheets, doesn’t seem to have hurt CAD at all. In fact, since the BOC QE program began, CAD has recovered most of its recent loss in value versus USD.

So, if unemployment, inflation, interest rates and quantitative easing don’t explain movements in CADUSD, what does? The answer seems to boil down to two factors: commodity prices and the pandemic.

Commodity prices seem to explain most of the variance in CADUSD. Specifically, an index of commodity prices weighted to reflect their importance to Canada’s economy, has tracked CADUSD extremely closely for over two decades. CAD fell with commodity prices in the first four months of 2020 but has subsequently rebounded as commodity prices came off their lows .

Both the U.S. and Canada have diversified economies with large service and manufacturing sectors. What differentiates the two economies, other than size, is that Canada is a large exporter of raw materials, unlike the U.S. The rise in U.S. oil production has made the country far less reliant on oil imports, but the country is still a net importer of crude oil. The U.S. is an exporter of agricultural goods, but a net importer of most industrial metals. By contrast, Canada is a net exporter of all three classes of commodities.

It could be noted that CAD has outperformed its commodity index in the past several months, rising more than expected under the circumstances. This may be the result of Canada reopening to a greater extent than the U.S. amid the pandemic. While the U.S. experienced a summer wave of infections, Canada did not.

The anecdotal evidence from restaurant activity suggests a more consistent rebound in economic activity in Canada during the summer months than in the U.S. As we have seen globally, however, the pandemic can take an unpredictable course. As such, alternative measures of economic health could give a sense of where currency markets might be heading.

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