The Correlation Between Crude Oil And The Canadian Dollar
Traders are constantly on the look out for shifts in market sentiment; inter-market correlations are another area that require attention, especially when looking at exchange rates from commodity exporting countries. Currency rates and oil prices are both asset prices which typically respond almost instantly to developments in Financial markets and economic news but this correlation is not static. This article looks at why the Canadian Dollar often trades inline with fluctuations in the price of oil.
Crude oil and the CAD (Canadian dollar) have historically maintained a strong correlation with each other. The Canadian dollar is indeed the embodiment of the term “commodity currency”. This is attributable to the fact that Canada has one of the largest oil reserves (only Saudi Arabia has a bigger oil reserve than Canada). It goes further than this though as a significant proportion of the aforementioned reserves in crude are destined for the neighbouring U.S; this makes Canada the largest source of energy for the United States. With this in mind it is easy to see why the CAD and Crude typically have a strong relative correlation as they are both traded against the U.S. dollar. Add to this the fact that approximately 85% of the exports from Canada head south to the U.S. When demand increases, manufacturers have to buy more oil in order to keep abreast of demand. This sometimes results in rising in oil prices, which can likewise see a falling USD/CAD currency rate.
The strong correlation between U.S. Equities & the CAD/JPY presently has the Canadian Dollar/Japanese Yen currency pair trading roughly in-line with U.S. equities. The chart below points towards a strong current relationship between those instruments and traders holding a belief that the S&P500 is heading higher (or lower as the case may be) might look to utilise this bias when trading the currencies.
Correlations can obviously change, this can sometimes manifest itself when risk aversion based flows dominate the FX market. These positive correlations are not always as strong. During the Financial crisis oil prices collapsed, as the U.S. Dollar appreciated, which is a divergence from the typical scenario where oil prices and the US Dollar are negatively related. The correlation between CAD and Oil has sometimes been a good area to exploit. However, crude oil can drop rapidly as the CAD ticks lower for the same time period. Oil can sometimes drop when the market attempts to price in potential changes in global demand, at the same time the Canadian dollar can trade in a consolidation range; perhaps caught between two strong support and resistance areas.
Assumptions that correlations are fixed can be misleading and are often too general in their nature. Recently the 30-day moving average correlation between the CAD and crude was at 0.86, this came as the currency had a 0.97 correlation reading against the S&P 500. With this information to hand it would have been wise to look at the S&P 500 price action as well as crude.
We can now look at the CAD and oil on the following chart. Over the last year, there has been a strong correlation of 95%; this subsequently weakened to just over the 40% level prior to regressing to “normal” levels. There was actually a negative period at the start of the year (within Jan and Feb) before a subsequent return to more typical correlation levels.
Canadian Dollar Oil Correlations
If the CAD currency finds strength at the same time as the price of crude oil, traders may decide to run with more traditional trading strategies. When there is a divergence in prices the trader needs to look for alternative strategies, or indeed wait until more typical correlations return. The following monthly timeframe chart shows a strong inverse relationship between USDCAD and US Oil. If you look closely you will see extended periods where Crude oil and the Canadian dollar had little or no correlation. Astute traders may often look to the Crude or Loonie charts in order to gain an insight into potential support and resistance. This information can be used when looking into potential trading opportunities on either instrument.
We can currently see that US Oil is in an uptrend when referencing the longer term Oil line chart below; at the same time we see that the Canadian dollar is trading strongly versus its U.S. counterpart. The USDCAD has hit a previous support level and could once again potentially see support or a breakout. As an interesting exercise you can keep an eye on the charts over the coming weeks and see how the two instruments (Loonie and US Oil) trade as price moves near/through important levels like this. You may even find it helps as a filter when looking at potential trade setups (try this on a separate Demo trading account). If you are interested in trading oil you can check out our Forex broker page, many of the brokers offer commodities for trading.
Canadian Dollar – Oil Overlay Chart