CAD-USD Commodity Correlations

The chart above is the DJ Commodity Index vs CAD-USD from 2007. The correlation of CAD with the DJ index is significant over the period at +0.76. What is interesting are periods of clear divergence between the two series. Have a look at the spike in CAD in 2007 to nearly 1.10. That spike correlated nicely with a sharp rally in the DJ commod index but as you can see the CAD rally turned out the be a short term spike while the commod index returns continued to motor higher. And when the DJ Index made a clear new high the CAD was in a long sideways period of consolidation. The period following is the two are pretty much in synch until you get to late 2010 when CAD forms a lovely double top and the DJ index fails to follow suit. After that they once again follow each other quite closely into a wider consolidation patter but once the DJ index shows some clear signs of breakdown CAD follows like an obedient servant. Fast forward to recent history and in the summer of 2015 the commod index forms a V shaped bottom and CAD does exactly the same. When commodities rally the CAD follows again until late 2016 and early 2017. CAD is now showing a bit of divergence, and what,  if anything, does this mean? 

Above is Dr. Copper over the same time period as the DJ index chart above. Notice that over this period the CAD- Copper correlation is higher still at +0.86. The is a similar divergence at the start of the period when copper forms a nice triple top but CAD keeps motoring higher to just shy of 1.10. As CAD comes off its spike Copper follows but there is once again a bit of divergence  in 2010 when Copper make a new high and CAD fails to retest is old high. On the follow CAD and Dr. Copper are pretty much back in synch as Copper tries  to take out the 4.00 level and fails, develops into a triangle consolidation pattern, which once it breaks down foreshadows weaker price trends for both. This patter holds until late in 2016 at the time of the US election copper breaks out of its 2.00-2.35 consolidation pattern, however this time CAD fails to follow. The same patter as we observed in the first chart above. 

Above is CAD vs. WTI over the same period as the two charts above. Notice, that in this case the positive correlation is lower than Dr. Copper, but higher than the DJ index. And as you can see again, there is a distinct divergence between WTI  and CAD when the CAD spike in 2007  is followed by a much later WTI spike that is not reciprocated in CAD-USD. The follow on action is similar to Dr. Copper & the DJ index but in this case WTI is consolidating in a rising wedge formation, while CAD is similar but showing clearer signs of weakness. The picture is a bit clearer if you look at it over a shorter time frame in the chart below.

WTI is having less of an effect as it tries to take out the $105-$110 area,  while CAD is steadily loosing ground. The CAD-USD price action is more in line with Dr. Copper than with crude. WTI crashes on the break of the wedge formation and in this case CAD follows suit. The two mirror one another into the low in WTI @$27-$28 forms a double bottom and they rally together until once again in early 2017 the two start to diverge. So what, if anything does this portend?  Here, for what it is worth,  is my biased opinion. While the positioning in the commodity markets, WTI and Copper, may well be long, and possibly stretched, this enthusiasm is not yet being shared by the commodity currencies, to the same degree. The current prevailing market bias is to run short CAD based on a number of macro factors. The macro indicators have been weak, at least until recently, and the economy is leveraged long to housing which may well be rolling over. Exports have not picked up to the same degree or in line with the 30% depreciation of the exchange rate. Finally the BoC current Governor has developed a bit of a penchant for a talking  the currency down. The argument back is that CAD is generally correlated to the so-called Global reflation trade. Admittedly, global PMIs were rising ahead of Trump's victory. It was interesting that the break higher in Dr. Copper occurred on the day of the US election, before the polls closed, and well before the results were in. The global reflation story was already starting to gain traction, but Trump election as we all know, ratcheted things up further with his infrastructure spending talk. If forced  to choose between China stimulus in comparison to Trump's reflation talk &  in terms of which will be the more salient factor, it is China and not the new US administration that will provide greater direction over the medium term. China, not the US, to put it bluntly   is the 800lb gorilla in the room. Having said that, it is doubtful we are in a secular bull market for commodities. At this point it is more accurate to say we are in a correction phase from a much longer term secular bear market. China stimulus measures may well be doubted, and fears of a hard landed are still justified, but one has to admit, the authorities seem to be doing a better job than their given credit by many (myself included) in their quest to re-balance the economy. Apart from China the rise in Global PMIs is real, even in Asia. Singapore's macro data which had been pretty weak in 2016 is turning around smartly. 4Q GDP announced on 3 Jan came in well ahead of expectations. Even euroscleroic Europe is showing signs of life, while  the UK enjoys a short term sugar rush from the 18% collapse in sterling. At the same time, US and even the more recent CAD macro data has been ahead of expectations. In equity land the reflation narrative has been central to the recovery in the high beta cyclical sectors, particularly those tied to the commodity complex, industrials, & financials. CAD and the commodity based currencies may well prove more resilient than expected in this environment. The price action will see more corrective periods of CAD strength with falling volatility as the CAD-USD continues its broad consolidation pattern. Option prices will get cheaper and skew will decline. Having said that however, the risk reward is asymmetrical. In other words, a clear break down the commodity index, copper, or WTI will lead to a much sharper sell-off in CAD.

What is more likely to account for the divergence between the commodity complex and spot CAD is the sharp narrowing in 2Y CAD-US interest rate differentials. As you can see above CAD has lost its positive spread vs the US two year.

In the same vein the chart above shows the spread between the average of 2s-5s-10s CAD-US interest rate differential (in blue) vs. spot USD-CAD (in red). Here too there are some interesting divergences. First at the left hand side of the chart in early 08 when the Dollar made a new low (CAD-high) in line with the differential narrowing, and then corrected back while the differential made a new low. A similar event occurred in 2008 with USD-CAD forming a double top around 1,3000 with the spread making a new high. And finally most recently in 2016 we are seeing the spread attempting to break to a fresh high with the spot below its previous peak. In order for CAD-USD to break down clearly, trends in the commodity complex have to be in alignment with the direction of interest rate spreads.

James