Canadian Dollar Gains as Oil Rises, Fed Outlook Softens

Key Moments

USD/CAD Under Pressure in Asian Trade

USD/CAD extended its recent slide for a second consecutive day during Asian hours on Thursday, trading around the 1.3800 level. The move reflected renewed demand for the Canadian Dollar (CAD) as higher crude oil prices underpinned the commodity-linked currency.

Oil Prices Rise Amid Middle East Tensions

Crude oil prices have advanced as geopolitical risks in the Middle East intensified and talks between the United States and Iran stalled. The confrontation has broadened to include the strategically important Strait of Hormuz, a major shipping lane for energy exports.

Despite this escalation, U.S. President Donald Trump indicated that oil traffic through the strait continues, while signaling that the possibility of future negotiations with Tehran remains open.

Brent Risk Premium Supported by Geopolitical Backdrop

Analysts at TD Securities highlighted that geopolitical developments remain a central driver for crude prices, cautioning that the “Iran conflict teeters on further escalation.” In light of the elevated regional risk and the threat of supply disruptions, TD Securities expects Brent’s risk premium to stay supported as market participants continue to price in the potential for additional instability.

US Dollar Softens on Data and Fed Expectations

The decline in USD/CAD has also been driven by weakness in the US Dollar (USD), as traders responded to recent economic data and shifting expectations for Federal Reserve (Fed) policy.

Minutes from the Fed’s July meeting showed that policymakers were inclined to raise interest rates in the near term if inflation did not ease, after previously holding the benchmark rate steady in the 3.5%-3.75% range.

Although inflation readings remain above the Fed’s 2% objective, recent monthly figures have suggested only modest price pressures, tempering the argument for more forceful tightening. These indications of cooling inflation have reduced expectations for an imminent rate increase.

According to the CME FedWatch Tool, markets are now assigning a 32.7% probability to a rate hike at the next Fed meeting, compared with 47% one month earlier.

Fundamental Drivers of the Canadian Dollar

The Canadian Dollar (CAD) is influenced by several core macroeconomic and financial variables. Key among them are interest rates set by the Bank of Canada (BoC), movements in oil prices given petroleum’s role as Canada’s largest export, the overall strength of the domestic economy, inflation trends, and the trade balance – the difference between the value of exports and imports.

Investor risk appetite is another important factor. Periods characterized by a “risk-on” stance, when investors favor higher-yielding or growth-sensitive assets, typically support the CAD. In addition, the health of the US economy is crucial, as the United States is Canada’s largest trading partner.

Bank of Canada Policy and Its Impact on CAD

The Bank of Canada exerts substantial influence over the CAD through its control of short-term interest rates, which determine the cost of interbank lending and help shape borrowing costs across the economy. The BoC’s primary objective is to keep inflation within a 1-3% range, adjusting rates higher or lower as needed to achieve that goal.

Generally, relatively higher interest rates are supportive of the Canadian Dollar. The BoC can also deploy quantitative easing or quantitative tightening to affect credit conditions. Quantitative easing is typically viewed as negative for the CAD, while quantitative tightening tends to be CAD-positive.

Oil Prices and the Canadian Dollar

Because petroleum is Canada’s largest export, fluctuations in oil prices have a direct and often immediate impact on the Canadian Dollar. When oil prices rise, demand for CAD generally increases, supporting the currency. Conversely, declining oil prices usually weigh on the CAD.

Stronger oil prices also tend to improve Canada’s trade balance, which can further bolster the currency by increasing net demand for Canadian exports and, by extension, for CAD.

Inflation Dynamics and Currency Performance

In modern financial markets, higher inflation can sometimes be associated with currency strength rather than weakness, due to the response of central banks. Elevated inflation often leads policymakers to raise interest rates, attracting capital inflows from global investors seeking higher yields. For Canada, this mechanism can increase demand for the Canadian Dollar when inflation prompts the BoC to tighten policy.

Economic Data as a Driver of CAD

Macroeconomic indicators serve as key signals for the Canadian Dollar’s direction. Data such as gross domestic product (GDP), manufacturing and services purchasing managers’ indexes (PMIs), labor market reports, and consumer sentiment surveys help investors gauge the health of the Canadian economy.

Robust data tends to be supportive of the CAD, as it can draw in foreign investment and increase the likelihood of higher interest rates from the BoC. Conversely, weaker releases typically put downward pressure on the currency.