Subprime crisis? Credit crunch? These issues have fallen by the wayside as the focus of investors, politicians and central bankers alike has shifted to the break-neck rise in oil prices. Concerns abound that the current rally will mirror the catastrophic economic fallout of the 1970s oil shocks. The parallels appear well-warranted: last week saw crude reach yet another record, trading at $139.12 dollars/barrel and surpassing the 1979 high of $136.28 (in today’s dollars). This weekend’s G8 Summit in Japan is set to focus on the matter as energy costs have crimped consumption, distorted trade figures, and fed global inflation. The markets will wait breathlessly to see if the final communiqué will include an unambiguous call on oil producing countries to boost production. With oil prices increasingly determined by the fate of the US dollar, forex traders will look to USDCAD to capture the volatility surrounding the meeting’s outcome.

Oil is the Primary Concern of Global Policy Makers

Global policy makers have been unanimous in voicing their concerns about the rising price of oil. Monday saw Federal Reserve Chairman Ben Bernanke signal an end to monetary easing, saying that “latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.” He added that "[the Fed] will strongly resist an erosion of longer-term inflation expectations, as an un-anchoring of those expectations would be destabilizing for growth as well as for inflation." The US is not alone – Japan’s Prime Minister Yasuo Fukuda appealed for a rise in oil production following a pre-G8 meeting with German Chancellor Angela Merkel, stressing that “Sudden rises in oil prices are hitting not only the world economy, but ordinary people's lives.” His Australian counterpart Kevin Rudd was less reserved, urging the G8 to “apply the blow-torch to the OPEC organization.” At one point or another, officials from every G8 country as well as those from China, India and South Korea have called on oil producers to increase supply.

Oil Prices Are in Step with the Direction of the US Dollar

All signs point to the conclusion that the fundamentals of crude production and consumption are not behind the current rise in prices. Rather, the current rally is primarily driven by speculative bets against the US dollar. As stocks fell to risk aversion and the US dollar tumbled, traders were desperate for a refuge destination to protect their assets. Blossoming demand for commodity imports from emerging markets such as India and China offered a rare positive story in an otherwise shaken marketplace, attracting huge inflows of speculative capital and leading prices to balloon higher. A recent analysis report prepared by Thomas Mayer and Torsten Slok of Deutsche Bank highlights this development, pointing to big differences in returns between commodities and other asset classes from one year ago.

A report from the Organization of the Petroleum Exporting Countries (OPEC) goes further still, noting that “the falling value of the US dollar has encouraged inflows of new money into the crude oil futures market…Crude oil prices have become detached from the dynamics of supply and demand fundamentals, since, in spite of the persistent price rises, the market remains well-supplied with crude.” In point of fact, the inverse correlation between the rate of change in the dollar index and that of the price of oil is at the highest in over a decade.

The G8 Could End the Oil Rally, Sending USDCAD Higher

A hawkish G8 communiqué could prove to be the beginning of the end for the oil rally, catalyzing the brewing shift in US economic fundamentals to favor of the dollar. The US has been proactive in dealing with the subprime crisis. The Federal Reserve had slashed borrowing costs by over 60% in recent months, creating incentives for spending and investment. The US government has also adopted fiscal stimulus package provide direct transfer payments as well as tax relief, both of which will increase disposable income and encourage consumption. The weaker dollar has boosted profits in the export sector, improving earnings and helping to rekindle an interest in US equities. With economic slowdown spreading globally, it is reasonable to think that traders will look to US Treasuries as a stand-by safe-haven asset, prompting an inflow of capital into American debt markets. The absence of further interest rate cuts will contribute to a re-alignment of yield gap expectations. These factors will prompt investors to buy dollars, with the subsequent appreciation in and of itself depressing oil prices as the dollar regains purchasing power.

USDCAD will offer currency traders a vehicle to trade the reversal in oil prices. Historically, the Canadian dollar has been highly correlated with crude, with the two tracking each other with over 80% precision. This is not surprising – Canada boasts the world’s second largest oil reserves (after Saudi Arabia). Canada is also the number one supplier to the world’s largest oil importer, the United States. As the price of oil goes up, Canadian firms benefit from greater export revenues, improving Canada’s trade balance and adding to positive growth in overall national income. The relationship has been particularly notable in the USDCAD pair because the global price of oil is denominated in US dollars. If the Canadian dollar is over 80% correlated with the price of crude, then one would reckon that an appreciation in oil would see an analogous depreciation in USDCAD over 80% of the time. While this correlation has been weak of late as oil made outsized leaps to record levels, instances of similar divergences in the recent past have been followed by sharp corrections, offering lucrative trading opportunities. Strong language from the G8 urging OPEC to increase supply would weigh on oil prices, and given improving US data coupled with the aforementioned correlation between oil and the dollar could send USDCAD higher as oil drops.

The Risks – Why USDCAD Could Go Down

With the summer driving season here and the Beijing Olympic Games fast approaching, the top consumers of oil in the United States and China are likely to remain active buyers. In fact, China has been rumored to be ramping up imports to build up stock piles of crude before prices reach even higher. Meanwhile, Canadian monetary authorities are no less worried about the inflation implications of dearer crude. Prices could reach so high that swelling oil export revenues will make it cost effective for Canadian companies to expand capacity. Firms will hire workers and invest in new buildings and machinery. As more people go to work, disposable income levels will rise, spurring consumption and ultimately overall GDP as well. The resulting buoyancy in the Canadian economy would invariably feed both headline and core inflation. The Bank of Canada has identified this risk already, having surprised the markets earlier this week by choosing to forego the expected rate cut and changing the accompanying rhetoric to project a decidedly hawkish tone. The bank noted that “many” of the previously feared risks to growth have moderated in recent months, revising upward its projections for GDP expansion for both 2008 and 2009. The statement concluded that the current policy rate was “appropriately accommodative”, suggesting rate cuts were over for the time being. A booming economy along with a shift in yield expectations may serve push up USDCAD, causing the pair to break out of its current range for a sharp catch-up correction to the rise in oil.

David Rodriguez is a Currency Analyst at FXCM.