EUR/CAD chart analysis: Could the euro fall to a 10-year low on tighter oil supply?
Updated
The euro-Canadian dollar (EUR/CAD) exchange rate has recently piqued investors' interest, as the price action has fallen to levels not seen since December 2012, almost a decade ago.
The pair's downtrend, which began in June 2020, has seen a further downward leg in recent months, owing to the widening of interest rate differentials and trade divergences between Canada and the eurozone. In addition to a hawkish Bank of Canada (BoC), which hiked interest rates by a full percentage point in July, WTI oil and natural gas prices have also boosted the CAD recently.
Overall, the major trend continues to be bearish. To see a trend reversal in EUR/CAD, the ECB must hike rates aggressively or global energy prices must fall significantly. Tighter oil supplies are putting more downward pressure on the pair, with Russia and OPEC+ adding supply uncertainties in the aftermath of progress on the Iranian deal. Rising chances of a severe global recession may alleviate downward pressure.
The next supports are 1.2577 (October 2012 lows) and 1.2130 (August 2012 low), which is 5.8% below current prices. Resistance is provided by 1.329 (mid-July 2022 highs) and the 1.34-1.346 region (early July highs and April-June support).
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EUR/CAD price chart: Approaching 10-year lows; weekly RSI enters oversold
EUR/CAD 1-week price chart as of August 24, 2022 – Photo: Capital.com, Source: TradingviewEUR/CAD fundamental analysis: Eurozone weakens, Canada thrives amid energy crisis
The EUR/CAD's downtrend has been driven by a sharp and gradual decline in the Eurozone's macroeconomic fundamentals and an improvement in Canada's.
This is evident in both the dynamics of trade and the difference in interest rates between the two regions. Rising oil and gas prices, which are key commodity exports for Canada but imports for Europe, have had a significant impact on the former, while a relatively more aggressive BoC a has given the CAD a rate advantage over the euro.
EUR/CAD: Interest rate differentials are historically wide
EUR/CAD exchange rate vs ECB-BoC policy rate gap – Photo: Capital.com, Source: TradingviewLet's examine the interest rate divergence between the eurozone and Canada.
Not only did the BoC start hiking rates much earlier than the ECB, but it has also been doing so much more aggressively.
The Bank of Canada (BoC) raised interest rates by a full percentage point in July, bringing them to 2.5%. This was the biggest rate increase since 1998, and it surprised analysts who had expected a 75bps increase. The BoC also indicated that it will raise interest rates further at its next meetings in order to combat rising inflation.
The European Central Bank raised interest rates by half a percentage point in July, the first increase in more than a decade, bringing the deposit rate to zero. The ECB has also made it clear that it plans to keep raising rates, but the market thinks that the severe recession that is coming to Europe will give the ECB less room to move rates up materially.
The current interest rate differential between the Eurozone and Canada is thus negative by 2.5 percentage points or 250 basis points, one of the widest spread in the last 20 years.
In line with interest rate differentials, the yield on a 2-year German bond is currently 255 basis points lower than the yield on a 2-year Canadian Treasury bond. This explains a significant portion of the decline in the EUR/CAD exchange rate over the past two years.
EUR/CAD vs 2-year Germany-Canada yield spread – Photo: Capital.com, Source: TradingviewEUR/CAD: Oil & gas prices affect relative trade performances and weigh on the exchange rate
Canada vs Germany terms of trade – Photo: Capital.com, Source: TradingviewCanada's trade terms are booming, while Germany's are plummeting precipitously. Concurrently, Canada's balance of trade is at the largest surplus since 2008, whereas the European Union's is at a record deficit.
This is merely the flip side of higher global energy prices, which benefit a net exporter like Canada and burden a net importer, such as Europe, which is also experiencing a domestic gas crisis.
Consistently high prices for oil and natural gas thus weigh on the EUR/CAD exchange rate.
EUR/CAD vs oil prices (WTI) – Photo: Capital.com, Source: TradingviewEUR/CAD outlook: more downside to come?
To witnees a clear trend reversal in the EUR/CAD pair, the underlying factors that caused the euro to fall against the Canadian dollar must also reverse.
In essence, aggressive ECB rate hikes, a more dovish Bank of Canada, and a material drop in oil and natural gas prices are needed.
To begin with, the European Central Bank will soon have to make some very hard decisions that could open up frictions between the "doves" and "hawks" within the board. Eurozone's inflation rate skyrocketed in July, reaching 8.9% year-on-year, and very pessimistic forecasts predict that Germany will experience inflation of 10% or higher in the coming months.
Naturally, this means higher rates in Europe, but the potential for a severe economic downturn means the European Central Bank may not be able to maintain a long cycle of rate hikes. Peripheral sovereign debts and spreads are also an issue that could experience extreme volatility if interest rates were to suddenly spike.
On the other hand, the inflation and job market dynamics in Canada do not indicate any dovish shift from the Bank of Canada in the near term. In July, Canada's annual inflation rate was 7.6%, easing from the previous month's 39-year high of 8.1% but in line with market expectations. The unemployment rate remains at record-low levels (4.9% in July). This essentialy gives the BoC the green light to keep hiking interest rates aggressively.
Therefore, policy rate divergences between the Euro area and Canada are unlikely to reverse soon.
Regarding oil prices, we have been witnessing renewed concerns regarding fresh supply disruptions in the global crude market. Any progress toward a deal with Iran is seriously hampered by OPEC+, which has threatened new production cuts to compensate for the eventual return of Iranian crude to the market. In addition, estimates suggest that EU oil sanctions against Russia will result in 1.25 mln/bd loss.
Backwardation in the oil market has recently increased as spot prices have begun to trade wider than longer-term futures deliveries, reflecting the tightening of the global crude market. Concerns about oil supply will boost the CAD at the expense of the EUR.
Bottom line, macro factors may continue to exert downward pressure on the EUR/CAD pair in the short-term. For the euro to really make a turn against the Canadian dollar, a severe global recession would need to occur, with deflationary effects on oil and gas prices.
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