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U.S. interest rates hold back loonie amid record oil prices

Geopolitical risk from Russia’s invasion of Ukraine has strengthened the U.S. dollar’s value
Ben Homsy, vice-president and portfolio manager at Leith Wheeler Investment Counsel Ltd., believes the interest rate differential with the U.S. drives the value of the Canadian dollar | Submitted

The Canadian dollar has lately been trading in a range around US$0.78 despite crude oil prices briefly nearing US$140 earlier this month for the first time since 2008.

The last time oil was priced that high, the loonie hovered around parity with the U.S. greenback.

Economists dubbed it a “petrocurrency” because its value hinged on the price for oil.

Currency watchers now say oil’s price has an impact on the Canadian dollar, but other factors, such as commodity prices, geopolitical risk, interest rates and the prospect for future interest rate hikes play at least as large a role.

“One of the misnomers in currency markets, is that the Canadian dollar is primarily driven by oil,” Ben Homsy, vice-president and portfolio manager at Leith Wheeler Investment Counsel Ltd., told BIV.

“More dominant than oil is the interest rate differential between the U.S. and Canada.”

He said that the key is not simply the absolute difference between the two countries’ interest rates, but whether that difference is changing, and if so, by how much.

The Bank of Canada on March 2 raised its overnight rate by 25 basis points, to 0.50 per cent, and has hinted more hikes are coming. Scotiabank (TSX:BNS) is forecasting Canada’s interest rate to be 2 per cent by the end of 2022.

Interest rates are also rising south of the border.

On March 16 the U.S. Federal Reserve raised the U.S. federal funds rate by a quarter point, to a range between 0.25 per cent and 0.50 per cent.

The median forecast from Fed officials is now to raise interest hikes seven times this year, to 1.9%. The bank's forecast is then for the federal funds rate to reach 2.75% by 2023.

Fed chair Jerome Powell told media in a March 16 Zoom call that it is "certainly a possibility, as we go through the year," that the fed would be even more aggressive with its hikes to interest rates.

He then, yesterday (March 21,) honed that thought in a speech at the National Association for Business Economics conference, and said that his central bank is prepared to raise interest rates in half-percentage-point increments.

The perception that Powell is becoming more hawkish on hiking interest rates has helped increase the U.S. dollar's value.

“I don’t like the term ‘petrocurrency’ because there is more going on in Canada than just the oil sector,” Scotiabank managing director and chief currency strategist Shaun Osborne told BIV.

Russia’s war on Ukraine ignited a chain of events, including global sanctions and the U.S. closing Russian oil imports. Speculation yesterday was that Europe may join the embargo on Russian oil, which helped push up oil prices. 

Russia's war in Ukraine has also prompted geopolitical risk, Osborne said. 

In times of war, and geopolitical risk, investors flock to safe haven currencies, and the U.S. greenback is perceived as the safest currency in the world.

The greenback is the currency of the world’s superpower, and it has for decades been the currency that other nations’ central banks most keep in reserve.

Simply keeping pace with the U.S. dollar as it strengthens is therefore an accomplishment for the loonie. If global tensions ratchet up more, the loonie is likely to underperform the U.S. dollar, said Osborne.

Canada’s comparatively small economy prompts it to have a more volatile currency than those of other industrialized nations.

The last time the loonie was on a brisk upswing was in May 2021, when it soared to a three-and-a-half-year high, above US$0.82. Much of what propelled it there, Osborne said, was good news: recovering domestic growth after the initial COVID-19 economic blow, gains in commodity prices and the first hints from the Bank of Canada that it would start to unwind its ultra-stimulative monetary policy of low interest rates.

Back in May, market watchers viewed the Bank of Canada as more hawkish on monetary policy than its U.S. peer.

The mechanics of why higher comparative interest rates prompt a higher currency include that those higher rates induce investors to buy Canadian bonds because the return is greater. In doing so, capital flows into Canadian dollars. 

When foreign investors buy other Canadian products, such as oil or commodities, the proceeds similarly flow into the Canadian economy, where capital is converted into Canadian dollars to circulate, and companies pay worker salaries.

Higher commodity and oil prices steer capital to producers, thereby stimulating Canada’s economy.

Another effect could be to boost Canada’s major bourse, the Toronto Stock Exchange (TSX) because that exchange disproportionally includes oil, gas and resources companies, compared with major U.S. exchanges.

“The TSX has certainly outperformed the U.S., and most global markets, year to date,” said Thane Stenner, senior portfolio manager with Stenner Wealth Partners+ at Canaccord Genuity Group Inc.

He said commodity prices may be near cyclical highs, although when he looks out more than five years, he believes commodity prices will be higher.

“The Canadian market will rotate a little and perform less well going forward in the second quarter as oil peaks, and there’s a possible war resolution,” he said. “The TSX has already been a top performer, but I wouldn’t chase it here.” • 

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