This week, the Canadian Dollar (CAD) could experience considerable volatility. Two major events are in the spotlight: the next decision by the US Federal Reserve (Fed) on Wednesday evening, and the surge in Oil prices fueled by tensions in the Middle East.
For investors, understanding how these two forces interact is essential to anticipating the evolution of the Canadian currency. With the CAD having touched successive fresh highs against the US Dollar this year, will the strength hold?
USD/CAD pair: daily chart. Source: FXStreet.
Why does the Fed influence the Canadian Dollar?
The Federal Reserve is the central bank of the United States. It sets the key interest rates that influence the entire US economy, and by extension, those of neighboring countries like Canada.
When the economy is overheating (high inflation), the Fed can raise its key interest rates to curb consumption and investment. Conversely, if growth slows, the central bank may lower interest rates to stimulate economic activity.
The Fed also publishes what is known as a "dot plot": a graph showing where each member of the committee expects interest rates to be in the months and years ahead. This is an invaluable tool for anticipating the evolution of monetary policy.
If the majority anticipates interest rate cuts, this tends to weaken the US Dollar. Conversely, expectations of higher rates for longer strengthen the US Dollar.
The CAD is highly sensitive to movements in the USD. When US interest rates remain high, global capital flows into US Dollar-denominated assets, which offer a better return. This reduces demand for the Canadian Dollar, and therefore the value of the CAD.
On the other hand, lower interest rates in the US reduce the attractiveness of the Greenback and may breathe new life into the Canadian Dollar. This rate differential – or "yield spread" – is a key driver of the USD/CAD exchange rate.
At its meeting on Wednesday, the Fed is expected to keep rates unchanged at between 4.25% and 4.50%. However, Fed Chairman Jerome Powell's communication and the publication of the new dot plot will be decisive.
Markets are waiting to see whether the Fed prepares a rate cut for September – which would be positive for the Canadian Dollar against the US Dollar, or whether it adopts a more cautious tone due to geopolitical tensions, signalling that rates will remain unchanged for longer, which could strengthen the USD and penalize the CAD.
Why Oil weighs heavily on the Canadian Dollar
Canada is one of the world's largest Oil exporters. When Oil prices rise, this increases the country's export revenues, improves the balance of trade and attracts foreign investment. This tends to strengthen the Canadian Dollar.
But if Oil prices fall or become volatile, the uncertainty can scare investors away, to the detriment of the Loonie.
Oil prices have soared since Israel attacked Iranian installations, fuelling fears of disruption to global supplies, notably via the Strait of Hormuz. This geopolitical shock has supported the Canadian Dollar in recent days, due to the strong correlation between Oil and CAD.
But this rise is fragile. If tensions ease or global demand weakens, prices could fall back, putting downward pressure on the CAD.
What can we expect for the CAD in the short and medium term?
The USD/CAD pair has been on a clear downtrend since March, touching lows not seen since October 2024. In the short term, the Loonie could continue to benefit from high Oil prices and a weaker US Dollar if the Fed confirms a future rate cut.
In the medium term, however, the situation remains uncertain. An economic slowdown in the United States, persistent trade tensions, or a further fall in Oil prices could weigh heavily on the Canadian Dollar.
What to remember
The Canadian Dollar is a sensitive currency, dependent on both Fed decisions and Oil fluctuations.
This week, traders and investors will have their eyes riveted on the Fed meeting and the energy markets. This is the ideal time to observe how the global economy and central bank decisions directly influence currencies.
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