More on CAD/USD & WTI

Mike Moffat on WCI posted a "toy" model relating CAD/USD to the price of oil and interest rate differential between the U.S. and Canada. I've reproduced his model below:

Using the daily data from the years 2001-2006 a linear regression was run to calculate values for the toy:

MERT value = 48.62 + (0.6211*OIL) + (1.8306*INTGAP)

where:

MERT = The predicted value of the Canadian dollar (CAD/USD)

OIL = WTI Cushing Spot price in dollars

INTGAP = Target for the Overnight Rate (Canada) - Target for the Federal Funds Rate (U.S.). A 1.25% target for the overnight rate enters the equation as 1.25.

Really quite a lovely "toy" which does a pretty good job in estimating the CAD/USD exchange rate (see the above link for some graphs of its predictive capabilities). I especially like the use of WTI as a predictive term. Now WTI is strongly correlated with the inverse of the US dollar. I believe the power of the "toy" in predicting CAD/USD stems from this strong correlation.

So I was wondering about my earlier use of CAD/EUR to gauge Canadian dollar strength independent of the US dollar and thought to examine that technique in light of this new "toy". Specifically, how does CAD/EUR compare to both WTI and the inverse of the US dollar (or the US Dollar Index).

WTI appears in the top panel as OHLC bars along with the inverse of the US Dollar Index as a blue line. CAD/EUR appears in the second panel as a green line along with CAD/USD as a red line. My apologies for the busy chart.

Note: WTI is plotted on a log scale, while the inverse of USD is on a linear scale!

via Stockcharts.com
It's immediately apparent that log WTI and the inverse of the US Dollar Index are strongly correlated (I looked at straight WTI versus inverse US Dollar Index, and the log appears to be a much better fit).

I've highlighted several periods where the two signal diverge. The yellow periods indicates instances where the US dollar weakens faster than WTI strengthens (that is inverse US dollar index rises above WTI). In these periods, CAD/EUR drops as the Euro outperforms the Canadian dollar. The tan periods are instances where Inverse US Dollar Index underperforms WTI (i.e., the US dollar strengthens while WTI remains strong). In these periods, CAD/EUR rises.

What I find very interesting is that when Inverse US Dollar Index diverges from WTI, CAD/EUR follows the US dollar (the dollar index itself, not the inverse). When the US dollar weakens faster than WTI falls, CAD/EUR falls (yellow periods), and when US dollar rises faster than WTI falls, CAD/EUR rises (tan periods).

If you examine CAD/USD (red line), whatever influence CAD/EUR has on the Canadian dollar appears to be dwarfed by whatever the US dollar is doing. Post 2003, CAD/USD and CAD/EUR appear correlated, but previous to this date, changes in CAD/EUR appear to have only a small correlation to CAD/USD.

Finally, it's important to note that this approach ignores other macroeconomic variables which could influence exchange rates. In particular, Mike Moffat's "toy" model includes the interest rate gap between Canada and the US.

Update: After further thought, I'm not sure that the above figure speaks one way or another on WTI's independent influence on CAD/USD. Now it is true that CAD/EUR tends to follow USD more than WTI (yellow and tan regions). But, this is probably happening because USD is moving more than WTI in each of those bands.

I think there are better approaches, but I'll post more when I get a chance.

Signs of improvement

While the bad news has been relentless these past few weeks, there have been signs that a recovery is just around the corner. Numerous correlational indicators have improved markedly since New Years, even in the face of the weakness in equities these past two weeks. These indicators include:

A huge decline in the A2/P2 spreads in 2009 (Calculated Risk) indicating that credit is beginning to flow again;

An increase in M3 Money Supply, indicating that the Fed's efforts to reinflate are getting traction;

An increase in 10 year Treasury yields, indicating an increase in risk appetite;

Bullish moves in silver and crude, silver in particular has been tightly correlated to SPX;

A weekly drop in the cash holdings of money market mutual funds, which might indicate that cash on the sidelines is coming back into the markets;

Continued improvement in the BDI, suggesting that global trade is starting to recover;

And strength in Markit's ABX and CMBX indices, again measures that are correlated to SPX.

All this is bullish for equities, although some indicators are becoming overbought (like TRIN from Matt Trivisonno)

Signs of improvement - silver and crude

Since last August, both silver and crude have been tightly correlated to SPX, with all three instruments being synchronized in the timing of their highs and lows. And while the heights of their respective highs and lows varied, the directions of their moves remain correlated. Silver and SPX, in particular, have been strongly correlated.

Below is a Stockcharts chart with silver and SPX in the top panel, crude ($WTIC) and SPX in the second panel, and silver and crude in the third panel. Note how the intermediate lows of the three instruments are synchronized, with silver's 52 week low being put in at the end of October, SPX's low on Nov 21st, and crude's low in late December.

Last week, silver managed to put in a lower high, and this past week, the metal put in a higher high, bullish signs that the uptrend will continue. This is in contrast to SPX, which was down on the week.

Crude, while not as strong as silver, managed a higher low before closing up for the week.

Given the past correlation to equities, these are bullish signs that stocks will rise.