Yet more on CAD/USD and WTI

This post continues on the discussion of the degree to which CAD/USD is influenced by WTI, and is primarily meant to add some colour to the discussion of a post by Mike Moffat over at WCI.

In earlier posts (here and here) I had argued that the price of CAD/USD was not directly influenced by the price of oil, but rather by US dollar strength (or weakness). My claim was supported by the fact that CAD/EUR, which should gauge Canadian dollar strength independent of the US dollar, was not particularly correlated to the price of oil.

Having thought about this a bit more, I want to expand on this discussion. Specifically, while it is true that CAD/USD is primarily influenced by the strength of the US dollar (as is the price of oil), one can discern periods where the price of oil is higher than one would expect solely from US dollar strength. During these periods, the Canadian dollar seems to outperform the Euro (that is CAD/EUR rises). This suggests that when the price of oil is higher than expected based on USD, it correlates with Canadian dollar strength. In other words, CAD/USD and the price of oil are correlated independent of the US dollar.

Below is a chart with WTI in the top panel on a log scale (OHLC bars). Superimposed in the panel is 1/US Dollar Index on a linear scale (which plots US dollar weakness). EUR/USD and CAD/USD are plotted in the second panel in blue and red respectively. CAD/EUR appears in the third panel.

My first comment is that log(WTI) seems to correlate much better with 1/USD than WTI, at least over the 2003-2010 period.

Second, I've highlighted three periods in tan where US dollar weakness (i.e., 1/USD) outperforms log(WTI) strength. During these periods, EUR/USD outperforms CAD/USD and CAD/EUR falls. I've also highlighted three periods in yellow where log(WTI) outperforms US dollar weakness. During these periods, CAD/USD outperforms EUR/USD and CAD/EUR rises.

Thus when WTI is stronger than what one would predict from USD (that is when log(WTI) outpeforms 1/USD), the Canadian dollar outperforms the Euro. Conversely when WTI is weaker than what one would predict from USD (1/USD outperforms log(WTI)), the Canadian dollar underperforms the Euro.

From this data I can't help but conclude that the price of oil has an independent correlation to the Canadian dollar (indpendent of the US dollar that is). But evidence of the correlation only appears when the price of WTI diverges from what one would predict solely on the basis of the US dollar.

I owe Stephen Gordon an apology for nitpicking to such a degree about his earlier post.