USD/CAD at make or break point
The Canadian dollar has been a big beneficiary of the secular bull market in oil. That’s because Canada exports copious quantities of crude. The country, in fact, is the tenth largest exporter of oil according to the CIA World Factbook.
As the price of oil rises, so, too, does the demand for the Canadian dollar. This relationship is readily observable in the cross rates that involve the Canadian dollar. Just pull up two- or three-year charts of the EUR/CAD, AUD/CAD, or GBP/CAD. You will find a steady trend of Canadian dollar strength concurrent to rising crude prices over the same period.
But a strange thing is happening right now. Crude is trading near all-time highs while the Canadian dollar is weakening. What gives?
The Canadian dollar began to show signs of weakness a few months back, after the Bank of Canada (BOC) hinted that it would pause its rate hikes. Confirmation of the pause came last week during the BOC’s most recent meeting, during which they committed to a pause. But in addition to officially pausing their hikes, the BOC revealed that the strong Canadian dollar could weigh on economic growth next year. This was a huge surprise to traders, who had been leaning to the long side in the Canadian dollar as revealed by the recent Commitment of Traders Report.
The outcome of the BOC’s meeting is best viewed through the Loonie, or USD/CAD. The short-term response was to buy the USD/CAD, which helped to finally break the pair out from its two month trading range. But the move left the Loonie at long-term descending resistance near the 1.1400 level.
The significance of the descending resistance level is revealed on a longer-term chart.
The long-term downward trend of the USD/CAD is still intact, despite the recent run-up following the BOC’s remarks. Further, the long-term trend in the USD/CAD is a product of rising oil prices, which are still rising.
If the BOC’s comments marked a significant fundamental change in the Canadian dollar, then the USD/CAD will soon break its long-term descending trend and move towards an intermediate-target of 1.1700.
Conversely, if the trend of rising oil prices continues, then the USD/CAD will likely rollover from its descending trend line and move back down to relative lows — about 400 pips away from the current rate.
There are a couple of different strategies that I would consider when looking to play this set-up in the Loonie. The first is through a directional trade, either through buying or shorting the USD/CAD. To the upside, I would look for the USD/CAD to exceed its short-term highs, and thereafter break through the descending resistance at 1.1400. To the downside, I would wait for a break and close below the 1.1300 level, where I would enter half a short position. I would leg into the second half of a short position on a break and close below 1.1250.
Alternatively, a trader could employ a market-neutral strategy through the use of options, either a vanilla straddle or neutral exotic. Buying one or two months should provide enough time to see the eventual move play out, which should be at least 300 pips.
Eric Utley is a full-time trader with over a decade of experience in equities, equity options, futures, and currencies. He specializes in trading currencies, using a combination of quantitative, technical, and fundamental analysis. He is the lead contributor to INVESToolsCT.com, manages a currency trading blog, produces educational programs, and hosts a weekly online seminar.