Canadian Dollar remains on the front foot vs softer USD; upside potential seems limited

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The USD/CAD pair struggles to capitalize on the overnight bounce from the 1.3900 mark, or the weekly low, and ticks lower during the Asian session on Thursday.

USD/CAD edges lower on Thursday, though it lacks follow-through amid mixed cues.
Rising Oil prices underpin the Loonie and cap gains amid a modest USD downtick.
Geopolitical risks and the divergent Fed-BoC expectations lend support to the pair.

The USD/CAD pair struggles to capitalize on the overnight bounce from the 1.3900 mark, or the weekly low, and ticks lower during the Asian session on Thursday. Spot prices, however, remain well within striking distance of the year-to-date high, touched on Tuesday, and currently trade just below mid-1.3900s, down less than 0.10% for the day amid mixed cues.

Iran announced the closure of the Strait of Hormuz after the US launched a fresh wave of strikes across the country under orders from US President Donald Trump. The latest developments help Crude Oil prices in recovering further from a nearly two-month low, touched on Tuesday, which is seen underpinning the commodity-linked Loonie. Apart from this, subdued US Dollar (USD) price action turns out to be another factor acting as a headwind for the USD/CAD pair.

Meanwhile, the risk of a further escalation of tensions between the US and Iran might continue to benefit the Greenback's safe-haven status. In fact, Iran’s joint military command said that its armed forces will give a “crushing and decisive” response to any “aggression” from the US in the region. Furthermore, the war-driven rise in energy prices continues to fuel inflationary concerns and bolster expectations for a more hawkish US Federal Reserve (Fed).

According to the CME Group's FedWatch Tool, traders are currently pricing in over a 70% chance that the US central bank will raise borrowing costs by the end of this year. The bets were lifted by Wednesday's report showing that the US Consumer Price Index (CPI) rose 4.2% YoY in May, marking its highest level in three years. In contrast, the Bank of Canada (BoC) maintains a dovish stance as policymakers are prioritizing a sluggish economy over inflation threats.

The divergent Fed-BoC policy expectations, in turn, should help limit the downside for the USD/CAD pair, making it prudent to wait for strong follow-through selling before confirming that spot prices have topped out. Traders now look forward to the release of the US Producer Price Index (PPI), due later during the North American session. This, along with fresh developments surrounding the Middle East crisis and Oil price dynamics, should provide a fresh impetus.

Canadian Dollar FAQs

What key factors drive the Canadian Dollar?

The key factors driving the Canadian Dollar (CAD) are the level of interest rates set by the Bank of Canada (BoC), the price of Oil, Canada’s largest export, the health of its economy, inflation and the Trade Balance, which is the difference between the value of Canada’s exports versus its imports. Other factors include market sentiment – whether investors are taking on more risky assets (risk-on) or seeking safe-havens (risk-off) – with risk-on being CAD-positive. As its largest trading partner, the health of the US economy is also a key factor influencing the Canadian Dollar.

How do the decisions of the Bank of Canada impact the Canadian Dollar?

The Bank of Canada (BoC) has a significant influence on the Canadian Dollar by setting the level of interest rates that banks can lend to one another. This influences the level of interest rates for everyone. The main goal of the BoC is to maintain inflation at 1-3% by adjusting interest rates up or down. Relatively higher interest rates tend to be positive for the CAD. The Bank of Canada can also use quantitative easing and tightening to influence credit conditions, with the former CAD-negative and the latter CAD-positive.

How does the price of Oil impact the Canadian Dollar?

The price of Oil is a key factor impacting the value of the Canadian Dollar. Petroleum is Canada’s biggest export, so Oil price tends to have an immediate impact on the CAD value. Generally, if Oil price rises CAD also goes up, as aggregate demand for the currency increases. The opposite is the case if the price of Oil falls. Higher Oil prices also tend to result in a greater likelihood of a positive Trade Balance, which is also supportive of the CAD.

How does inflation data impact the value of the Canadian Dollar?

While inflation had always traditionally been thought of as a negative factor for a currency since it lowers the value of money, the opposite has actually been the case in modern times with the relaxation of cross-border capital controls. Higher inflation tends to lead central banks to put up interest rates which attracts more capital inflows from global investors seeking a lucrative place to keep their money. This increases demand for the local currency, which in Canada’s case is the Canadian Dollar.

How does economic data influence the value of the Canadian Dollar?

Macroeconomic data releases gauge the health of the economy and can have an impact on the Canadian Dollar. Indicators such as GDP, Manufacturing and Services PMIs, employment, and consumer sentiment surveys can all influence the direction of the CAD. A strong economy is good for the Canadian Dollar. Not only does it attract more foreign investment but it may encourage the Bank of Canada to put up interest rates, leading to a stronger currency. If economic data is weak, however, the CAD is likely to fall.