By Kathy Lien – DailyFX.com – Oil prices are on the rise once again and this time crude is setting fresh record highs in the… … process.

In the past month alone, crude prices
have increased by a whopping 21 percent, leading many to ask how much
longer can this rally continue. The latest round of oil strength stems
from Iran's announcement that they have successfully enriched uranium
for the very first time. Geopolitical tensions are rising as the oil
market fears that the US may respond with an attack on Iran, the holder
of the third largest oil reserves in the world. The US does not import
any oil from Iran, but many countries such as Russia, China and some
European nations do. With prices so high, gas at the pumps has hit $4
/gallon in Beverly Hills while some pumps are going dry at Philadelphia
area gas stations. Yet when the mania hits a peak and everyone is
screaming that things will only worsen, we may be near a top. Just look
back at the hysteria points in August 2005 and February 2006. In both
rallies, prices first rose by 26 and 21 percent respectively. At the
time, the market became extremely concerned, gasoline prices skyrocketed
and unsurprisingly, oil prices tipped over shortly thereafter to erase
at least two thirds of the gains before rising once again. Therefore,
it is quite likely that we are at same turning point in oil at this
moment, especially since prices have already rallied 26 percent. Back
in November and December of last year, when we were entering the winter
season, the prospects for oil looked the most dismal because energy
usage at that time was a necessity. Now in contrast, even though we are
moving into the usually busy summer driving season, taking extra road
trips with the kids is something that can be avoided.

Retracement Waves in Oil

If history is a reliable barometer, then we expect another retracement
“wave” in oil. According to the chart below, each rally wave lasted
only 2 months before reversing. We have just begun the second month of
the rally, which means that we could see a bit more of an extension, but
the additional percentage gain should be limited. However once the move
lower occurs, judging from previous retracement moves, we could easily
see a $10 drop in crude prices.

USD/CAD * The trade to turn to if oil crashes

If oil crashes, there will be ripple effects on many economies. In the
Middle East, a lot of wealth and home valuations are tied to oil, making
it even more important for those traders to look for hedging
opportunities. The same is true here in North America. Canada's
booming economy has been fueled by the climb in oil which has benefited
domestic corporate profitability. It has also sent the Canadian dollar
to 28 year highs against the US dollar by boosting the international
purchasing power for Canadians. As the world's second largest holder
of oil reserves, Canada has been one of the primary beneficiaries, which
means that if oil crashes, it will also be the currency that will suffer
the most.

In contrast, the US stands to benefit greatly if oil prices slide. For
months now, there has been a widespread fear that the rise in oil could
weigh heavily on consumer spending. With the housing market bubble
already posing a big risk for the economy, the potential impact of
skyrocketing oil on spending has been one of the biggest arguments
against a prolonged Federal Reserve tightening cycle. The lower the
price of oil, the more stimulative it is for the US economy as
discretionary income of US consumers increases. Therefore if oil does
crash, this fear of an economic slowdown will be greatly alleviated and
be taken as a promising sign by dollar bulls. Of course, this may bring
up the question that since oil is priced in dollars, why wouldn't the
dollar suffer from a decreasing value of oil purchases. The answer is
the same answer as why the dollar does not benefit from the higher price
of oil. It is because a lot of central banks already have reserves in
dollars and the same is true for companies, which means that they do not
need to convert additional money into dollars in order to fund new
purchases.

This makes the long USD/CAD trade the perfect hedge against falling oil
prices. The chart below shows the close correlation between Oil and
USD/CAD (inverted in graph). When oil prices rise, USD/CAD falls and
vice versa. Since the beginning of 2004, the correlation between these
two products has been a strongly negative 86 percent. On top that,
sliding oil prices would bring about improvements to the US economy and
the prospects for higher US interest rates. For Canada on the other
hand, the Canadian economy would suffer and in the extreme scenario,
forcing the Bank of Canada to cut short their tightening cycle. In the
extreme scenario, they may even opt to reduce interest rates, which
would hurt the Canadian dollar significantly. For the time being, the
differential between the rates in the US and Canada is 100 basis points,
which means that for each day a trader holds one regular lot of USD/CAD
on the long side, the trader would earn $2.80 in interest income, a
benefit that short oil contracts do not offer. Therefore USD/CAD is a
very interesting trade to look into if you think the oil move is
overdone and may due for a retracement.

USD/CAD * Already Battered

Furthermore, USD/CAD is already trading not far from its 28 year lows,
suggesting that support may come in soon enough for the currency pair.
It was only four years ago that the dollar was trading at 1.60 against
the loonie and we are already showing signs that the sell off may be
nearing an end. For three consecutive months, USD/CAD has touched the
same lows and failed to break through, making it an even more attractive
trade if you need to hedge against a slide in oil. Eventually, as oil
continues to rise, the benefits for the Canadian economy will also begin
to subside. The market tends to forget that Canada is also a huge net
exporter to the US. Therefore the stronger the loonie, the weaker the
exports. Canadian automobile exports have already begin to suffer.

Kindest Regards,

Kathy Lien
Chief Strategist
Forex Capital Markets LLC
32 Old Slip, 10th Floor
New York, NY 10004
Tel (212) 897-7660
Fax (212) 897-7669
E-mail: klien@fxcm.com
www.dailyfx.com

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