Oil and Economy Pull the Canadian Dollar Lower

Our informal and simple model for the Canadian
dollar has three variables.
  Oil, interest rates, and general risk environment.  Over time, the
coefficient of the variables can and do change.  

Of the three variables, the general risk
environment is the most supportive of the Canadian dollar.
Between the BOJ and ECB more than $150 bln a month of central bank, credits are being created.  This is one of the key factors driving interest
rates down in Europe and Japan. 

Equity markets have generally recovered from the wobble after the UK referendum, but
not necessarily because of stronger growth expectations.
  Rather lower
bond yields may force some classes of investors into the equity market. 
Consider the dividend yield of major equity markets: S&P 500 yields 2.1%,
the Topix yields 2.2%, Toronto’s stock index yields almost 3% and Dow Jones
Stoxx 600 yields a little more than 3.65%.   

As a way to quantify risk appetites, use the
S&P 500.
  Over the past 60 days,
the correlation of the percent change of the S&P 500 and the Canadian
dollar is about 0.59.   Although the correlation was a little tighter
in the March-April period, it is still the upper end of what it has been since

However, the other two variable, oil and
interest rates are drags on the Canadian
  Oil prices are near three-month lows.  With US rig count
rising again, and apparently in productive fields, and output also turning
higher (past two weeks), supply concerns rise.  Also, as the US driving
season ends, refiners often shut down for maintenance.  Some of the oil surpluses appear
to have been siphoned and created a
surplus of gasoline.     

The correlation of the change of the Canadian
dollar and change in oil price (front-month contract for light sweet crude)
over the past 60 sessions is near 0.60.
  With a couple of exceptions,
the correlation is as high as it has been over the past five years.  

The two-year Interest rate differentials
between US and Canada has also begun moving against the Canadian dollar.

Near the middle of January, before the US dollar bottomed against the Canadian
dollar, the US offered nearly a 60 bp premium over Canada.  The premium
fell to almost five bp on July 5. 
It is now at 16 bp which is just below the 50-day moving average.  

The 10-year interest rate differential appears to be offering better guidance for the
Canadian dollar than the short-end.
  The US 10-year premium over Canad
peaked at the end of last year near 90 bp.  It retests it in late-January as the US dollar peaked against the
Canadian dollar near CAD1.4700.  The US premium trended lower, reaching 32
bp in late-April.  The US dollar bottomed against the Canadian dollar on
May 3 near CAD1.2460.  The greenback has been trending higher, and it reached its best level in three
months yesterday near CAD1.3245.  The 10-year premium is near 45 bp

Canada is one of the few major economies that
report monthly GDP estimates. 
At the end of the week, the May
estimate will be released.  The median forecast is for a contraction of
0.5%.  That follows a 0.1% expansion in April,
which snapped a two-month contraction.  Since the middle of 2014, there
has only been one-quarter (Q4 15) in
which the Canadian economy expanded for each of the three months.   
The 0.5% contraction, though, would be the largest since last September and
third decline in four months.   

Canada’s contraction will stand in stark
contrast to the US, which will report the first estimate of Q2 GDP at the same
. The Atlanta Fed’s GDPNow tracker estimates Q2 GDP at 2.4% before the US durable goods order report
today.  It will update its estimate later today, but we expect it to be downgraded to 2.2%.   

In recent sessions, demand for US dollar
emerged near the five-day average, which is found at CAD1.3160 today, which
currently is day’s low. 
A break could see CAD1.31.  We still
like the upside, and we continue to look for a test on the CAD1.33.  That
area corresponds to a 38.2% retracement of this year’s decline and houses the
200-day moving average.


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