Weaker link between loonie and crude worsens BoC woes

Decoupling CAD-oil relationship leaves central bank with less leverage to fight inflation, according to macro strategist

Weaker link between loonie and crude worsens BoC woes

The historic relationship between the Canadian dollar and energy prices has weakened, leaving the Bank of Canada with one less instrument to fight inflation as the Russia-Ukraine crisis forces crude oil to its highest level in 14 years.

Because of the close relationship between the Canadian dollar and oil, the central bank has traditionally been able to use a stronger currency to alleviate inflationary pressures brought on by increased energy prices. Gains in the loonie would lower the cost of imports into Canada.

But according to a report from Reuters, this is not the case in the current cycle. The energy crisis is also weighing on the outlook for the global economy, creating a headwind for risky currencies like the loonie and more demand for the safe-haven US dollar.

Eric Theoret, global macro strategist at Manulife Investment Management told Reuters: "There is a kink in the CAD-oil relationship. You are not getting the currency strength that would dampen inflation."

The Canadian dollar was at 1.09 per US dollar, or approximately 92 cents, the last time oil went above $100 a barrel, in 2014. It's currently hovering at 1.28.

Meanwhile, according to Refinitiv Eikon data, the 3-month rolling correlation between the Canadian currency and oil has dropped to 0.3 from 0.9 in December, getting closer to the zero level that indicates no connection.

"What we've seen over the last month or two has definitely been a quite significant outlier in what has been historically a very steady and pretty consistent relationship," Shaun Osborne, chief currency strategist at Scotiabank, told the news outlet.

"We would probably be in a situation here where the Bank [of Canada] would not be pushing back against the idea of a stronger Canadian dollar," he added.

Economists predict that rising commodity costs will push inflation considerably higher in the coming months.

According to strategists polled by Reuters, higher oil prices will support the loonie in the coming year, but this will be due to an improvement in Canada's terms of trade, or the ratio of export prices to import prices, rather than a projected increase in investment.

After the anguish of 2020's pandemic-induced oil price crash, Canadian firms are reluctant of spending aggressively to increase oil output.

Investors are demanding rigorous financial discipline even as environmental opposition to new fossil-fuel projects, along with the Canadian government's plans to curb carbon emissions, stifles growth.

"The era of 'drill, baby drill' is over in America and it's the same kind of discipline in Canada," said Adam Button, chief currency analyst at ForexLive, referring to a political slogan of the U.S. Republican Party.

"Oil isn't the driver [of the Canadian dollar] it once was," Button stated.