USD to CAD: Bank of Canada Ahead, Merrill Lynch Forecast CAD Losses Now But Recovery seen on Bullish Oil Prices in 2017

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How might the US dollar / Canadian dollar exchange rate react to today's Bank of Canada event? We look at this question while also noting some incisive analysis concerning the outlook from Bank of America Merrill Lynch.

The USD/CAD exchange rate trades at 1.3106 ahead of the Bank of Canada meeting due on Thursday the 25th of May.

No changes are expected but how USD/CAD trades in the days ahead could be largely determined by the central bank's tone.

"After a week of steady gains, USD/CAD is beginning to lose momentum and continued optimism by the BoC could erase more gains," says Kathy Lien, analyst with BK Asset Management.

The last time they met, the BoC left interest rates unchanged and upgraded their 2016 GDP forecasts.

However it may be difficult to remain optimistic in the face of slowing consumer spending and after the wildfires in Alberta that could stall the recovery.

Aside from the weakness in spending, jobs were lost, building permits and housing starts declined, the trade deficit widened and overall growth slowed.

Yet consumer prices increased significantly with year over year CPI growth hitting 1.7%, manufacturing activity accelerated and Western Canada Select oil prices are up 30% since the last meeting.

"So there are still reasons for the central bank to be optimistic and that's what makes predicting the BoC's bias so difficult," says Lien.

Merrill Lynch: USD/CAD Back to Mid 1.30's

Fresh institutional research on the Canadian dollar's outlook suggests the USD/CAD is in the first stage of a rally back to the mid 1.30’s as WTI Crude Oil is at risk for a retracement to the mid $30’s.

The view is issued by Bank of America who simultaneously hold a more bullish view on the oil price over the longer-term timeframe.

Assimilating both BofA's near and longer-term views could hold the key to how trade in USD/CAD is likely to play out from here.

From a technical perspective, USD/CAD began a reversal near the bottom of the Ichimoku cloud support of 1.24.

USD to CAD rate

"MACD is deeply overextended and starting to turn up. Momentum as shown by RSI is beginning to recover from an oversold level it hasn’t seen in years. Price has rallied straight up to an area that has previously resulted in a pause due to the 2015 and 2010 highs," says Paul Ciana, technical strategist with BofA.

However Ciana anticipates crude oil will decline and be a catalyst for driving USD/CAD higher.

Fibonacci shows a rally to the 38.2% retracement of 1.3312, which aligns with the
bottom of the Ichimoku cloud, is a likely target. The 50% retracement of 1.3575 is a
second plausible target. We also see some historical significance to the 61.8% level of 1.3839 (based on price action earlier this year) that makes it a possible outcome and is contingent on the depth of the crude oil decline.

Longer-Term: Above Consensus Oil Price Recovery Forecast

The link between the Canadian dollar and oil prices is widely documented; over the last ten years the correlation has been 0.78 (1.00 being 100% correlated and 0.00 being 100% negatively correlated).

That means if the price of oil goes up so does the value of CAD.

Oil is Canada’s largest single export and therefore the single biggest contributor to Canada’s balance of payments account, which of course, is central to foreign exchange valuations.

When foreign buyers purchase oil from Canada they have to pay for it in Canadian dollars increasing demand for the currency and therefore upping its value.

Were the oil price slump we would expect demand for Canadian dollars to decline too.

Analysts wishing to forecast the Canadian dollar therefore often focus on analysing the price of oil because of this relationship.

Forecasting Notably Higher Oil Prices

Recent forecasts from Bank of America Merill Lynch show oil rising to 61 dollars a barrel in 2017 as a result of increased emerging market demand.

“In our view, the strong EM oil demand uplift is likely the beginning of a structural trend as car proliferation in India takes off. So we reiterate our view that Brent crude oil prices will average $61/bbl next year compared to an expected average of $46/bbl this year as the global oil market moves into deficit.”

They argue that whilst car ownership in the developed world is already high, there is still potential for increased ownership in emerging markets, such as India, which is increasingly taking over from China as the largest importer of oil in the region:

“Emerging Market demand momentum has been building for the last two years, averaging 1.5 million b/d YoY in the last four quarters, up from 1.0 two years ago. Our analysis shows that Emerging Asian countries have some of the highest sensitivities of oil demand to changes in crude oil prices."

As such, most of the recent EM demand acceleration comes from Asia, as India gradually becomes the engine of demand growth.

BofAML note Indian demand rose by 10% year-on-year in 1Q16, much more than the 3% and 4% reached in China and other EM Asia, respectively.

Implications for the USD to CAD Outlook

If the Canadian dollar is sensitive to the price of oil then the USD/CAD is doubly so, since the largest importer of Canadian oil is America.

If BofAML’s bullish oil outlook come to pass then this indicates downwards pressure on the US dollar to Candian dollar exchange rate pair.

It is even possible the pair may be affected in the short-term before the effects on demand BofAML’s research shows actually materialise, since markets often react to expectations as much as realities.

Currently the pair is pulling back up after reaching a long-term low at 1.2458 on May 3.

It has formed a three wave ABC correction, or measured move, indicating that the pull-back has probably run its course and should now start to move lower again in line with the dominant down-trend.

For ultimate confirmation of more downside a break below the current 1.2458 lows is advocated, with the next target at the 1.2175 where the 200-month moving average rests, and will present a formidable obstacle to further downside.