The principal drivers of the Canadian dollar/U.S. dollar exchange rate are changes in oil prices, changes in the difference between short-term U.S. and Canadian interest rates and stock market volatility (a proxy for risk appetites). Over the past ten years, oil price declines, shrinking premiums on short-term Canadian interest rates over U.S. ones, and rising stock market volatility have all tended to coincide with Canadian dollar weakness (see chart below). The reverse is also true.
Almost as soon as 2020 began, the Canadian dollar started its descent. Falling oil prices were the principal driver of the loonie’s initial weakness in January and February. By March, stocks and heightened risk aversion joined up with an oil price rout that deepened into April, leaving the loonie more than 10% below where it began the year. The difference in short-term interest rates has been essentially neutralized as a driver of the exchange rate this year, since the U.S. Federal Reserve and the Bank of Canada lowered policy rates by the same amount to effectively zero.
In our view, oil and interest rates will likely have a more muted impact on the Canadian dollar post crisis. Let’s start with oil. Global oil demand is likely to come back online far slower than the broader economy, given bans on – and consumer preferences against – airline travel, as well as greater acceptance of remote learning and working. More entertainment at home and less travel to stores and malls also likely keeps transportation demand subdued. Further production cutbacks beyond those announced a few weeks ago among oil producing countries are likely needed, including in Canada, to limit oversupplied conditions and further stockpiling.
These developments likely keep oil prices from rising materially above U.S.$30/barrel for West Texas Intermediate for the foreseeable future, even once the economy begins to normalize. The near-month crude oil futures price, which fell briefly into negative territory last week, was partly a technical condition related to poor liquidity and an unwillingness to take delivery of more barrels when the market was already over-supplied and storage tanks were nearing capacity. Prices recovered somewhat, but the near-month contract is still trading below U.S.$20/barrel, and futures prices don’t crest above U.S.$30/barrel until next year (see chart below). But while a recovery in oil prices would likely be a welcome relief for the loonie, sub-U.S.$40/barrel oil prices would likely imply still weak foreign investment flows into the Canadian energy sector.
As for short-term interest rate differentials, there is every reason to believe the Fed and the BoC will keep rates anchored at near zero for the foreseeable future. And given the giant hit to the energy sector and its larger share of the Canadian economy, there may be a valid reason for the BoC to move more slowly to begin raising interest rates when the worst of the crisis passes.
With oil prices and interest rates having less influence, we think gains in the Canadian dollar from here will likely be driven by declines in stock market volatility and improved investor risk appetites. And yet, even when the Canadian dollar does eventually recover when the economy returns to normal, there’s an argument for the loonie to trade in a lower range than it did pre-crisis, given the hit to energy and the resulting reduction in portfolio flows.
Kurt Reiman is a Managing Director and BlackRock’s Chief Investment Strategist for Canada. Kurt is a regular contributor to The Blog in Canada.
Daniel Donato is an Associate within BlackRock’s Toronto office.