The major macroeconomic factors, defining currency exchange rate are discussed. Correlation between oil prices and current account balance for Canada is outlined. An“abnormal” state of futures market, known as “backwardation”, is described. An indispensable feature, signifying minimum in oil prices, is proposed as a corollary. Further dynamics of the Canadian dollar is discussed.

It is ubiquitously acknowledged that the main driving forces behind currency dynamics, absent the Central Bank interventions, are interest rates spreads as well as current account and capital account balances. Provided that the former parameter is negligibly small or kept unchanged for long period of time, the importance of the latter parameters increases.

When commodity price holds the key to currency exchange rate

Canada is a perfect case of a country that developed commodity oriented economy. Advantages as well as drawbacks of so lopsided economical structure are simple to grasp – current account as well as capital account balances (see fig. 1 and fig. 2) become prone to the vicissitudes of world demand for a certain raw material. This high demand might be invoked by legitimate growth of economies around the globe or by credit expansion in commodity importing countries, such as US. Either way the immediate consequence of increased demand is higher price for raw material (see fig. 3) that translates into higher current account surplus and attracts more capital from abroad.
Data: St. Louis Fed
Fig. 1. Total Current Account Balance for Canada, mln USD

Data: St. Louis Fed
Fig. 2. Total Net Capital Account for Canada, mln CAD

Indeed, this significant swings in current account and capital account balances exert some pressure on national currency (see fig. 4). Since the prices for commodities are quite volatile by its very nature, this force, driving the currency exchange rate, is not
Data: St. Louis Fed
Fig. 3. Annually averaged price of WTI, USD per barrel

Data: St. Louis Fed
Fig. 4. Annually averaged USDCAD

sustainable over the long period of time, especially if this higher demand comes from credit expansion that might abruptly end. Thus, prognostication of further developments in commodity market is essential for analysis of long-term trends of commodity currencies.

Contango and backwardation – the “normal” and “abnormal” states of futures markets

Contango – state of futures market when the price of contracts maturing in more distant future is higher than the price of contracts maturing sooner. Backwardation – state of futures market when the price of contracts maturing in more distant future is lower than the price of contracts maturing sooner.
It should be noted that in contango state the spot price is below the price of the nearest futures contract, while in backwardation – higher. These peculiarities, hardly noticeable and rarely discussed, might be used as indispensable tools for the better comprehension of price dynamics in commodity markets and have profound effect on the actions of commodity hedgers.

When the futures market is in contango state, the commodity producers might exploit the spread between spot price or the price of the nearest futures contract and more distant contract by selling the latter one and buying the former, extract profit and accumulate commodity while hedging price risks. Such activity, purely speculative by its nature, serves the society in general – the excess reserves of commodity are being created and maintained; at the same time, it makes perfect sense to consider this spread as a price of commodity storage. Indeed, this state is deemed by many to be the “normal” state that allows the above mentioned activity to takes place; it should also be noted that more than 95% of the time the futures market for any type of commodity exists in this “normal” state.

When the market is in backwardation these spreads cannot be used for accumulation and storage of commodity – the reserves are not refilled but rather tapped that creates excess of commodity on the spot market and drives the price down. Indeed, such a state is not sustainable and deemed to be “abnormal” by market participants. The most important repercussion though is that the return to “normal” state can be achieved only during the downswing in spot prices since delta – the first derivative of futures contract with respect to underlying asset – is less than 1 (one).

The indispensable feature of sustainable CAD rally

Considering that the current state of futures for light sweet crude oil is backwardation (see fig. 5) the market participants should not be surprised that spot prices head lower; any meaningful upswing cannot be sustained over prolonged periods of time, despite the massive credit expansion in the US and around the globe.
Data: CME
Fig. 5. Backwardation in light sweet crude oil futures market, USD per barrel

Indeed, backwardation is the meaningful feature, not the reason, of oil glut and should be taken into account only as such. It would be sensible to suggest a corollary that the downside swing in spot oil price will go on until the futures market return to its state of contango. Only after that the upside potential for oil prices can be fully tapped.

Canadian dollar, being a commodity currency meaningfully correlated with oil prices, is too vulnerable to prolonged downswings in oil prices. It would be reasonable to anticipate further weakening of CAD so far as the oil prices keep on going down. As mentioned above the signifying feature of oil prices minima would be the return of futures market to the“normal” state that also might signal that major trough in the Canadian dollar exchange rate is in place. Until then any rally in CAD should be greeted with justified skepticism.
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