AUD/CAD Could Weaken As Oil Market Stability Strengthens Case For Canadian Comeback

The AUD/CAD currency pair, which expresses the value of the Australian dollar in terms of the Canadian dollar, sets two commodity currencies against each other. This year, one of the most monitored commodities has been crude oil, which is a key export of Canada. Australia is in fact a net-importer of the same crude oil products that Canada is a net-exporter of, and as such the collapse in oil prices has largely improved the case for AUD/CAD upside.

Therefore, in spite of the decline in the first quarter of the year, AUD/CAD has ended the year significantly higher. The more recent rally has also been boosted by significant monetary interventions, particularly in the United States in which the short-term interest rate (as set by the Federal Reserve) was cut from a range of 1.50-1.75% to just 0.00-0.25%. As a result, discount rates on investments collapsed, and newly-introduced QE measures further compressed risk premia, enabling risk assets (most notably equities) to find all-time highs, in spite of technical recessions registering across all major economies.

The effect on AUD/CAD has been like that of the roller coaster. As the daily candlestick chart below illustrates, after falling by more than 11% in the first quarter, AUD/CAD has rallied by over 18% (to the most recent closing price at the time of writing on October 2, 2020).

(Source: TradingView)

During global risk-off events, while CAD can be expected to concede strength to safe havens such as USD and CHF (just as AUD and NZD also fall; these are also considered commodity currencies like CAD), AUD generally weakens more than CAD. This is because Australia is a smaller and less sophisticated economy.

Smaller economies do not necessarily find that their currencies weaken as a result of risk-off events; Switzerland is tiny as compared to the euro area in aggregate, yet CHF has remained in high demand relative to the euro. Indeed, the smaller size of the Swiss economy (and the market for CHF versus EUR) has probably enabled much of this strength. Rather, it is the small size that amplifies outcomes, and this applies to Australia too. Flows out of smaller currency markets (e.g. CHF and AUD) simply place greater pressure on these markets. Therefore, risk-off moves can push CHF significantly higher and AUD significantly lower; the chart below shows that, as compared to the 11.40% drop in AUD/CAD, the first quarter saw AUD/CHF drop by over 21%.

AUD/CHF Price Action in 2020(Source: TradingView)

We might have expected AUD/CAD to have traded in a similar fashion (pushing even more harshly downward) if oil markets were stable throughout 2020, and if the crisis was mostly limited to China (which is a key trade partner of Australia). However, since oil markets have collapsed and the COVID-19 pandemic seems to have pervaded practically the entire world, short-AUD flows had a more limited effect on the AUD/CAD rate, as CAD was similarly shunned in FX markets. After markets later adjusted, AUD was favored (being a net beneficiary of both oil prices and improved risk sentiment), while CAD has generally continued to languish.

Now, in a relatively more stable environment, AUD/CAD is trading within a fairly tight range (since around June).

AUD/CAD Trading Range in 2020 (Source: TradingView)

In a world where uncertainty is as high as it is, it is fairly impressive for two commodity currencies to be trading in such a tight range. I would interpret the reduced volatility as a likely indicator of fairly stronger support and resistance at the 0.93 and 0.97 handles, respectively. Absent another significant global shock, breaking out of this range is likely to require some significant economic divergences.

The current short-term rate of the Reserve Bank of Australia is +0.25%. The comparable rate of the Bank of Canada is the same (it is also the same as the Reserve Bank of New Zealand; see a complete table here). Therefore, as interest rates have been cut to the zero lower bound, inflation rates become more important. Lower inflation rates (or deflation) strengthens inflation-adjusted yields (i.e. “real yields”), while higher inflation rates worsen real yields. In Q2 2020, Australian inflation was deflationary at -0.3%. While Canada dipped into year-over-year deflation in April and May 2020, more recently inflation has been positive (albeit by just 10 basis points in July and August). In effect, this means that the implied real yield for AUD is higher than the implied CAD real yield at present, but the difference is low, and the fact that CAD inflation appears to be fending off deflation is perhaps a constructive sign for longer-term Canadian rates.

Australian GDP sank by 6.3% in Q2 2020, as compared to Canadian GDP which sank by 13%. A sharper contraction from Canada, having likely been priced in by now (considering the tighter trading range, as mentioned previously), could indicate the potential for a sharper reversal to the upside later. If Canada can prove able to recover its lost ground against Australia (relatively speaking), AUD/CAD may readjust lower.

In addition to interest rates, inflation and growth, another useful model is Purchasing Power Parity (or PPP). This measures the relative purchasing power of different currencies, relative to current market exchange rates. The OECD’s PPP model currently suggests that (in 2019) the U.S. dollar was worth 1.44 AUD and 1.194 CAD. Using these figures, we can find an implied fair value for AUD/CAD of about 0.83. This compares to the current market price of 0.9527 at the time of writing. In other words, the current market price for AUD/CAD might be overvalued by as much as 15% (using our 2019 fair value estimate).

The trend was positive for this pair, but since June we can seen consolidation. In effect, the trend has broken; price action is largely horizontal. Should Canada bounce back more sharply than Australia (without significant inflationary pressure relative to Australia) which we might be able to say is probable, we might see some short- to medium-term downside pressure for AUD/CAD. At the very least, as we move into 2021, the January 2020 opening price would seem like a not-so-distant price level for the market to test the strength of the AUD/CAD rate. This presents a possible target of 0.91.

AUD/CAD versus January 2020 Opening Price (Source: TradingView)

It is also interesting that our 2019 fair value estimate effectively represents the key level of support that AUD/CAD bounced off of, in March 2020 (around this year’s reactionary lows). It is not inconceivable that AUD/CAD trades as low as this level once again in the medium to long term; however, this would likely require a significant resurgence in the global energy sector (possible, but certainly not a base-case scenario).

The oil market is at least more stable for now, and this will help to prevent the terms of trade differentials between Australia and Canada from widening further. Provided oil prices are able to fend off downside volatility through the rest of 2020, into 2021, we might see AUD/CAD concede its strength by first breaking its current trading range below the 0.93 handle.

Even if inflationary pressure is higher in Canada, this would support the potential for higher rates in Canada in the longer term (relative to Australia). While higher inflation might lend to a higher AUD/CAD fair value, the current market price is still safely above the 2019 PPP estimate at 0.83 (per our OECD model), and as such it is likely that AUD/CAD will remain fairly overvalued on a PPP basis over the next 12 months regardless of any inflation differentials (at least within reasonable bounds).

I think that the upside in AUD/CAD might be capped in the short to medium term, and perhaps even in the long term. The 0.91 level, at which AUD/CAD opened in 2020, is likely to serve as a next logical target for the pair. After this, we should look to the potential for even lower prices; while the lows of March 2020 might be a little too ambitious, the 0.86 handle (being the midpoint of the wide and volatile trading range in March 2020) might serve as a longer-term target.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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