The effect falling oil prices could have on the Canadian Dollar (CAD) and Bank of Canada interest rates

25th February 2015 by LauraParsons

The Canadian Dollar (CAD) has been on a wild ride in the past six months as a result of plummeting oil prices and Bank of Canada (BOC) action. Canada’s largest export is crude oil; therefore, any fluctuations in black gold directly affect the ‘Loonie’ (as the Canadian Dollar is otherwise known) exchange rate. Oil has fallen by around 60% since mid-July leaving Canada’s export profitability to suffer and the Canadian commodity currency to tumble as other currencies rallied around it.

However, the fall in oil had bigger consequences than a lower Canadian Dollar exchange rate. The slip in black gold caused inflationary levels the world over to decline and central bankers began to fret over the potential consequences. The Eurozone has struggled with deflation in recent months and the effect tumbling oil values had on Consumer Price Indexes (CPI) made the situation look worse. Moreover, the global economy has faced speculation of stagnation; a weaker 19-nation Eurozone, a slowdown in China and escalating deflationary fears for many nations caused the panic to heighten. The Canadian economic recovery also looked less stable with weaker oil prices hindering sentiment.

So what happened? Cue the Bank of Canada (BOC) taking markets by surprise. The Bank of Canada was the first of the major central banks to announce it was cutting interest rates this year—an event that led to weaker high-risk currencies such as the Australian and New Zealand Dollars (AUD, NZD), as investors forecast interest rate cuts from the Trans Tasman central banks. Market actions can have a domino effect, with one action rippling through to other nations and their respective currencies quite rapidly.

The Bank of Canada’s interest rate had remained at 1.0% for four years before it took a cut of 25 basis points to 0.75% in January. The central bank had earned a reputation for being rather immovable on the subject of interest rate hikes amid speculation of a possible domestic housing bubble.

In the aftermath of the BOC rate cut, the Reserve Bank of Australia (RBA) announced it would also be cutting its benchmark rate by 25 basis points. Not only this, but the Bank of England (BoE) and the Reserve Bank of New Zealand (RBNZ) adopted a dovish tone, leaving behind hawkish comments from previous statements.

With a global slowdown upon us and so many central banks fearing the effect of lower oil prices, what could happen in the near future? If the price of oil remains low, or drops even further, inflationary levels will continue to soften. The Bank of England (BoE) has suggested that if the UK economy suffers with persistently low inflationary levels, the central bank may be forced to hike interest rates quicker than previously forecast to encourage growth.

However, the Canadian economy isn’t looking too bright at the moment, with Canadian full-time job growth slowing and confidence decreasing. The central bank could cut rates again as layoffs in the oil sector contribute to a surge in joblessness and a lack of sentiment amongst citizens.

In addition, Bank of Canada Deputy Governor Carolyn Wilkins hinted that further rate cuts could occur, saying: ‘If potential output growth turns out to be lower than we think, we have the tools to bring inflation back to target.’

If the central bank does decide to cut rates again, it could be that other central banks remain poised to cut rates themselves. If a global slowdown does indeed occur, interest rates could remain low in many economies for a prolonged period.  However, a silver lining for the Canadian Dollar exchange rate and economy comes in the form of forecasts for an oil price recovery. If the value of black gold does rebound to around $80 a barrel before rising back to above the $100 mark in time, Canadian exports will become more fruitful and the central bank may be able to avoid cutting rates again.

 

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