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Oil Hits Record $120:Trade it with USDCAD

Commodities are rallying, with oil leading the way. Just today, prices surged to a record $120 per barrel. Skyrocketing crude prices have been a recurring theme in recent months - as stocks fell to risk aversion and the US dollar tumbled, traders were desperate for a refuge destination to protect their assets. Blossoming demand for commodity imports from emerging markets such as India and China offered a rare positive story in an otherwise shaken marketplace, attracting huge inflows of speculative capital and leading prices to balloon higher. Crude has gained 22% since January alone. Energy costs have spurred inflation, depressed consumption, and distorted trade figures in nearly every G7 economy. Just as observers were starting to grapple with the idea of oil reaching $100 per barrel, it became apparent that $200 a barrel had nearly arrived.

A recent analysis report prepared by Thomas Mayer and Torsten Slok of Deutsche Bank points to a big difference in returns between commodities and other asset classes from one year ago:

Why is USDCAD Correlated with the Price of Oil?

Historically speaking, the Canadian dollar has been highly correlated with the price of oil, with the two tracking each other with over 80% precision. This is not surprising – Canada boasts the world’s second largest oil reserves (after Saudi Arabia). Canada is also the number one supplier to the world’s largest oil importer, the United States. As the price of oil goes up, Canadian firms benefit from greater export revenues, improving Canada’s trade balance and adding to positive growth in overall national income. The relationship has been particularly notable in USDCAD. This makes sense because the global price of oil is denominated in US dollars. If the Canadian dollar is over 80% correlated with the price of crude, then one would reckon that an appreciation in oil would see an analogous depreciation in USDCAD over 80% of the time.

US Slowdown Holds USDCAD in Place as Oil Rallies

Currently, we can see that the correlation between USDCAD and the price of oil is very weak. Nearly 80% of Canadian exports are destined for the US market, making Canada highly sensitive to the slowdown in the States. Most metrics of Canadian economic heath have started to deteriorate:

    •     Employment is accelerating lower as firms cut capacity in the face of slowing US demand.
    •     The trend in trade figures points to further downside.
    •     Overall GDP has plummeted to the lowest level in 2 years.
    •     The Bank of Canada issued two deep back-to-back rate cuts of 50 basis points each, stating more easing is on its way.

Put simply, the two North American economies will rise and fall together, locking USDCAD in place.

The recent past has seen several notable instances where the USDCAD and oil relationship has broken down. In each case, this has led to sharp corrective moves (see Figure 2). If past price action is any indication, we would expect a deep correction to re-align the current imbalance, creating a very lucrative USDCAD trading opportunity.

Think Oil Will Continue to Go Up? Sell USDCAD

With the summer driving season and the Beijing Olympic Games fast approaching, the top consumers of oil in the United States and China show no signs of slowing down. In fact, China has been rumored to be ramping up imports to build up stock piles of crude before prices reach even higher. It seems only a matter of time before prices reach so high that swelling oil export revenues will make it cost effective for Canadian companies to expand capacity. Firms will hire workers and invest in new buildings and machinery. As more people go to work, disposable income levels will rise, spurring consumption and ultimately overall GDP as well. The Canadian economy will thereby be able to decouple from the US crisis, building positive growth momentum in spite of slowdowns in non-oil export sectors.

As vibrant economic growth resumes, the specter of inflation will move the Bank of Canada to abort their campaign of rate cuts and start gearing up to move monetary policy in the opposite direction. The newfound health of the Canadian economy and expectations of a widening yield gap will catalyze the USDCAD, causing the pair to break out of its current range for a sharp catch-up correction to the rise in oil. Not only does this offer a second chance to get in on the rally already seen in oil futures, but the yield-bearing nature of currencies will allow FX traders to magnify their gains as they capture positive overnight interest for every day that they hold a short USDCAD position.

Think Oil is About to Peak? Buy USDCAD

A report published by the Organization of the Petroleum Exporting Countries (OPEC) noted that “the falling value of the US dollar has encouraged inflows of new money into the crude oil futures market…Crude oil prices have become detached from the dynamics of supply and demand fundamentals, since, in spite of the persistent price rises, the market remains well-supplied with crude.” Traders have not discounted the apparent drag of the US slowdown on global growth, a trend that would cause oil demand to ease as consumers face deterioration in disposable income and pare back expenses. This has not caused oil to decline, suggesting speculative bets against the US dollar rather than the fundamentals of crude production and consumption are behind the spectacular rise in prices.

The US has been proactive in dealing with the current crisis. The Federal Reserve has slashed borrowing costs by 60% in the past six months, creating incentives for spending and investment. The US government has also adopted fiscal stimulus package provide direct transfer payments as well as tax relief, both of which will increase disposable income and encourage consumption. The weak dollar will help boost profits in the export sector, improving earnings and rekindling an interest in US equities. As the slowdown spreads globally, traders will look to US Treasuries as a stand-by safe-haven asset, prompting an inflow of capital into American debt markets. All this will prompt investors to buy dollars, with the subsequent appreciation in and of itself depressing oil prices as the dollar regains purchasing power. This will send USDCAD higher all the while oil drops lower, correcting the current distortion.

The Gap between Oil and USDCAD Offers a Historic Trading Opportunity

The magnitude of the current disparity between oil prices and the USDCAD exchange rate compared to those in recent history suggests a major trading opportunity. While many will look to the spectacular rise in crude and wish they could have capitalized by entering the rally at the ground level, this opportunity offers an outlet to trade oil as it stands today, regardless of whether a trader is bullish or bearish going forward. A genuine arbitrage opportunity from a mis-pricing in the market is a rare find in today’s instant electronic marketplace. The distortion in the correlation between USDCAD and oil offers just such a trade.

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