- Developed market FX tied to U.S. S&P 500

- CAD has strongest correlation

- Biden win in U.S. vote could spur CAD gains

- Oil prices waning as an influence

Image © Adobe Stock

The foreign exchange market is being lead by U.S. equity markets according to research from BNY Mellon, and of all the major currencies it is the Canadian Dollar that is displaying the strongest correlation.

Research from the U.S.-based lender and investment bank shows the U.S. stock market is arguably the most important driver of developed market currencies at present, owing to the paradigm shift in financial markets following the onset of the coronavirus crisis which prompted a substantial fiscal and monetary response from U.S. authorities.

"Day-to-day movements in risk (using the S&P as a somewhat and admittedly crude measure of risk appetite) are the predominant driver of Developed Market FX at the moment," says John Velis, FX and Macro Strategist, Americas, at BNY Mellon.

According to research conducted by Velis, the linkage between stock markets and the world's major currencies is however a relatively recent phenomenon.

"We interpret this unusual state of affairs as policy and political risk on steroids. The US election, where a Biden victory is still the predominant scenario according to the polls, is top of mind. If Biden does perform in line with the current polls, we’d view that as short term positive for the equity markets, a negative for the dollar, and a positive for the major crosses as a result," says Velis.

In short, "G10 FX is currently a USD story, which is a risk appetite story, which is a policy and politics story".

Image courtesy of BNY Mellon

The correlation of the Canadian Dollar with the U.S. equity market "is the highest in the G10 and its USD beta is almost exactly 1," says Velis.

"This underscores the view that what happens to the USD is what happens to CAD, and what happens to the USD is what happens with the equity market, which is itself a function of policy and political risk – currently, the Fiscal 4.0 discussion and the odds of a Biden victory," says Velis.

Image courtesy of BNY Mellon

A long-held view in foreign exchange circles is that the Canadian Dollar has a strong linkage with the value of oil, owing to Canada's sizeable oil industry.

However analysis from BNY Mellon shows that the correlation between CAD and oil has broken down of late, in fact it is now at historical lows.

"Persistently low volatility in oil prices is partly to blame for the weak relationship between the loonie and oil," says Velis.

The price of WTI oil has traded steadily around $40 per barrel level, and out to the end of next year futures are only $2 higher than at present.

Demand for 2021 is only expected by analysts to rebound slowly, given a lacklustre outlook for a slow grinding recovery globally and the resurgence of coronavirus cases in Europe and the U.S.

What does the outlook hold for the Canadian Dollar?

According to Velis, idiosyncratic drivers could make a come-back, given the primary drivers of a currency are ever-changing. (For the latest institutional GBP/CAD forecasts, with input from JP Morgan, Morgan Stanley, Citi and Lloyds, please see the latest forecast guide from our partners at Global Reach, here).

With the Canadian Dollar tuned into the U.S. market, how investors respond to the upcoming U.S. election will be key to how the currency ends 2020.

Analysts at Barclays are backing a stronger Canadian Dollar into year-end on the view that a convincing Biden win - and a Democrat win of the Senate - will prove positive for 'risk on' assets, including CAD.

"The CAD remains one of the best performers amongst its G10 peers recently and in the short-term is driven by the global risk backdrop and broad dollar moves, and we continue to expect a stronger loonie once the uncertainty around US elections dissipates," says a weekly client note from Barclays.

Stock markets are already pricing-in a Biden win in the U.S. presidential election in 11 days – and, against conventional wisdom, a Democrat victory will be welcomed by investors says Nigel Green, the CEO of de Vere Group. The comments come after President Trump and Joe Biden faced off in their final 2020 presidential debate on Thursday night.

The candidates sparred over the coronavirus pandemic, the stock market, the economy, immigration and foreign policy.

"The last debate was certainly more civil than the previous encounter, but it didn’t add much more to what we already know about the candidates’ personal and policy differences," says Green. "Therefore, we can expect the markets to continue pricing-in a Biden win, something which has begun in earnest in recent weeks."

The main risk to the outlook for stocks, and by extension the Canadian Dollar, is if the polls start to narrow and question the assumption for a 'blue wave' outcome to the vote, leading to the prospect of a contested election result.

Markets are likely to remain largely rangebound until any risks associated with U.S. politics dissipate.