USD/CAD Outlook: Bearish Price Action Throws Doubt on Bullish Macro Case

• Canada inflation undershoots despite oil shock from Iran war
• BoC core inflation gauge already running beneath Q2 forecast
• Canadian economic surprises weakest since October 2022
• USD/CAD prints topping signal despite rampant US dollar strength
• Repeated rejection above 1.3750 warns upside momentum may be fading

USD/CAD Refuses to Follow the Script

Canada just delivered an inflation undershoot that should have seen USD/CAD launch like a rocket, especially with the big dollar ripping higher against the other major currencies on Tuesday. Instead, the pair printed what looks like a topping signal. Throw in the growing divergence in economic momentum between Canada and the US and, fundamentally, USD/CAD should be out in the woodshed getting smashed to pieces. But it isn’t.

Soft Inflation Clouds Hawkish BoC Outlook

The inflation details only deepen the puzzle. Headline CPI rose 2.8% from a year earlier in April, undershooting expectations for a 3.1% increase despite the surge in gasoline prices following the Iran war. On a monthly basis, CPI rose 0.4%, below the 0.7% pace expected.

Source: TradingView

More importantly for the Bank of Canada, the underlying inflation pulse softened further. The annual rate of CPI median slowed to 2.1% from 2.3% while the annual pace of CPI trim eased to 2.0% from 2.2%. Averaging the two, the Bank’s preferred core inflation gauge now sits at 2.05%, already running beneath the Bank’s own Q2 forecast of 2.1% only one month into the quarter.

That matters because it calls into question whether markets have become too aggressive pricing Bank of Canada hikes later this year. The Bank of Canada has repeatedly warned about second-round inflation effects becoming embedded in broader pricing behaviour, but so far there’s little evidence of that emerging in the data.

Economic Momentum Favours USD

Source: LSEG

The broader macro backdrop only deepens the contradiction. Canada’s Citi economic surprise index, shown in red above, has fallen to the weakest level since October 2022 while the US equivalent, in blue, remains firmly in positive territory, continuing a trend that has persisted for almost a year. In simple terms, Canadian data has increasingly undershot expectations while US data continues to outperform.

That matters because a weakening domestic economy should help reduce the risk of the second-round inflation effects the Bank of Canada has warned about becoming embedded in broader pricing behaviour. Yet despite that backdrop, markets still imply around an 80% chance of a 25 basis point Bank of Canada hike by October. That seems very aggressive.

Price Action Over Macro

The unique structure of USD/CAD may explain the macro divergence. Unlike most major FX pairs, there’s little evidence that it’s tightly driven by any one macro force, whether that be rates, risk sentiment or even oil prices.

That’s important in this environment given both the United States and Canada are major energy exporters. While geopolitical tensions in the Middle East have generated violent swings elsewhere across FX markets, the relative impact on USD/CAD appears far less pronounced given both economies are exposed to the same positive terms of trade shock.

Source: TradingView

The correlation matrix above reinforces the point. Over the past month, USD/CAD has shown only a modest inverse relationship with S&P 500 futures at -0.47 and an even weaker positive relationship with Brent crude at just 0.12. The relationship with US Treasury futures has also been inconsistent, sitting at -0.34 against US two-year note futures over the same period before weakening further over longer horizons.

In other words, USD/CAD currently lacks the kind of obvious macro relationship seen regularly in other major pairs. That’s one reason why I place greater weight on the price action recently rather than trying to force a fundamental explanation onto every move.

Bears Defend 1.3750 Again

Source: TradingView

As correctly flagged earlier in the month, we've seen a nice bullish move in USD/CAD in May, seeing it retrace around half the bearish unwind of April. However, while the trend is undeniable, just look at the price action seen above 1.3750 over the past three sessions. It has acted as both support and resistance for lengthy periods dating back to late last year, and with three consecutive large topside wicks but no successful close above the level, it gives you the sense the market really doesn't want to see the pair higher.

Tuesday's candle stands out in particular, delivering something akin to a shooting star, a bearish reversal pattern that warns of potential downside. The domestic data was weak, the USD was rampant elsewhere, and the bears still lined up to push it back below 1.3750. That's something to sit up and take notice of.

While the oscillators are generating the mildest of mild bullish signals on directional risks right now, with RSI (14) above 50 while MACD has flipped positive having already crossed over earlier this month, the message is hardly definitive. If the price action is reflective of what's to come, short setups may be on the menu.

If the price continues to falter above 1.3750 or cannot reclaim the level today, positions could be set below with a tight stop above for protection, targeting lower levels. Early doors, there are several key levels nearby that may provide early hurdles for bears, with the 50 and 100-day moving averages, along with 1.3710, creating something of a potential support zone immediately under where the pair now trades.

Some may want to wait for a reversal beneath the zone before entry, but if the pair were to break through it, there's little in the way of visible support until 1.3600 down to 1.3550 where the pair bounced on several occasions earlier this year.