EUR/CAD: Potential For Bearish Reversal
The EUR/CAD currency pair, which expresses the value of the euro in terms of the Canadian dollar, has consolidated in a rather volatile fashion in recent weeks. The pair has traded between 1.52 and 1.60 through most of March 2020, after surging by about 10% from February 20, 2020 to March 9, 2020 (see the daily candlestick chart below).
(Chart created by the author using TradingView. The same applies to all subsequent candlestick charts presented hereafter.)
The pair has surged in line with the fall in the Canadian dollar (or CAD), which correlates strongly with oil prices, as oil-related products represent a major export category of Canada’s (see chart below).
(Source: The Observatory of Economic Complexity. The chart shows crude petroleum being the largest export category of Canada’s, in addition to other oil-related export categories.)
Oil prices have fallen precipitously, sparked by an oil price war between Saudi Arabia and Russia. In short, the COVID-19 pandemic has created a significant demand-side problem, as businesses have shut down and billions of individuals in developed markets have been told to stay at home (examples include lockdowns in Italy and the United Kingdom, although the shock to businesses and the changes in consumer behaviors have spread across the globe). With less movement of goods and people, oil is in less demand.
Therefore, the Organization of the Petroleum Exporting Countries (OPEC) has naturally had to respond to the threat of the virus. Yet, since Russia is also a significant oil exporter, OPEC has sought cooperation from Russia, as otherwise any cuts would produce a zero-sum game in which Russia would win (by not also cutting its oil production and supply). A fallout between OPEC and Russia has driven Saudi Arabia (the most powerful member of OPEC) to cut aggressively in retaliation to Russia’s lack of cooperation; they are now producing over 12 million barrels per day (maximum capacity).
The chart below shows Brent crude oil prices moving into 2020; the drop in the price has been sudden and cataclysmic.
WTI crude oil prices have similarly tumbled, as depicted in the daily candlestick chart below. Brent crude oil originates from oil fields in the North Sea, between the Shetland Islands and Norway, while West Texas Intermediate (or WTI) crude oil is sourced from U.S. oil fields. To illustrate the positive correlation between oil and CAD, the chart below also shows the inverse of EUR/CAD (i.e., CAD/EUR) per the green line set against the far-right y-axis.
The strong, positive correlation is evident, and the drop in the Canadian dollar has been supported by this move. The relationship is causal, not merely temporal; a reduction in oil prices means that some of Canada’s key exports are worth less than they would otherwise be. This is related to the concept of Terms of Trade: the ratio between the values of a country’s exports and imports. A lower oil price weakens Canada’s terms of trade and, thus, the value of its currency. CAD is the oil of the FX world; it functions like a derivative of the oil price.
The Canadian dollar has fallen in light of the drop in the oil price, but also because the country’s central bank (the Bank of Canada) has cut its interest rate to just +0.25% this year (from +1.75% at the start of the year, a time when the Bank of Canada had the highest interest rate among the G10 nations). A lower interest rate makes a currency less valuable to hold, and thus generally less attractive to buy (all else equal).
Further, since oil exports are important to Canada, so is the oil industry more broadly. If the Oil & Gas industry in the country needs to downsize, this naturally means that more employees will be out of work. Employees that are out of work will have no income if they cannot find replacement work (and possibly still a lower level of income even if they do), hence they will spend less. Since one man’s spending is another man’s income, this could (and likely will) ripple throughout the economy.
This concept of reduced spending causing reduced incomes applies throughout the world in light of the COVID-19 pandemic. The pandemic is causing businesses to shut and consumers to stay indoors and, consequently, spend less. Highly leveraged businesses are therefore subject to an increased risk of corporate failure. The following chart, taken from Wikipedia (which reports IMF data), shows that in 2018, Canada was one of the highest-leveraged economies (in terms of corporate debt-to-GDP).
As highlighted (by the author) in the chart above, Canada’s corporate debt-to-GDP stood at 117.77% of GDP in 2018.
There are plenty of reasons to be bearish the Canadian dollar. However, while CAD is likely to continue to remain bearish for the time being, the recent consolidation does suggest potential for either continued stability or a reversal. Yet, the only way that CAD is likely to stage a comeback is if OPEC and Russia make headway in terms of attenuating their current oil price war which has raged havoc in oil markets. At the moment, this does not seem likely, but we should also be open to the possibility of military conflict, which tends to occur more frequently in times of economic chaos.
The long-term monthly candlestick chart below shows that EUR/CAD is currently trading at a key level, in line with a long-term descending trend line which began in the early 1990s.
Notice that in each month that the pair trades to the top of this range, in accordance with the long-term trend, the following month tends to stage the beginning of a significant reversal. What we will need to see this month, in April 2020, is EUR/CAD staying under approximately 1.57 (or, at the very least, under the high of March 2020 of under 1.60).
If history repeats, we may find that the Canadian dollar is able to consolidate and find some support at these possibly stretched levels. However, CAD support would be contingent on the likely requirement that both Brent and WTI crude oil prices stay above the USD 20 handle. A sustained drop below $20/barrel could spark a significant breakout to the upside for EUR/CAD.
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.