Canadian Dollar Forecast: USD/CAD Hinges on US Inflation Data as Fed Weighs Path

USD/CAD OUTLOOK: SLIGHTLY BULLISH

• USD/CAD has been trending higher in recent weeks despite the moderate retreat over the past few days and heading into the weekend
• Broad-based U.S. dollar strength and oil market weakness have been two bearish catalysts for the Canadian dollar since early August
• The August U.S. inflation report will be a key volatility driver for the FX market next week

Most Read: US Dollar Price Action Setups - EUR/USD, GBP/USD, USD/CAD and USD/JPY

USD/CAD has been running higher since last month, bolstered primarily by widespread U.S. dollar strength. Weakness in oil, one of Canada's main exports, may have reinforced these bullish moves, weighing on the country's terms of trade. In recent days, however, the exchange rate has retraced some of this advance to trade a touch below 1.3050 before the weekend, but is still up more than 1.5% in total since August.

Although past performance can give traders important insight into trends and sentiment from time to time, it cannot reliably predict the future. This begs the question: where might USD/CAD be headed in the near-term based on the latest developments on the economy and monetary policy front?

In the coming sessions, USD/CAD will likely track the broader trend of the U.S. dollar, meaning that developments in the Canadian economy, while still relevant in the grand scheme of things, may temporarily take a back seat. That said, next week will bring major U.S. economic reports that could set the tone for financial markets, the most important being fresh CPI numbers due for release on Tuesday.

Traders will closely examine the data to predict how the Federal Reserve may respond to incoming macro information. Focusing on consumer prices, August headline inflation is seen flatlining on a seasonally adjusted basis (0.0% m-o-m), an outcome that could push the annual rate to 8.1% from 8.5% in July. Meanwhile, Core CPI is expected to clock in at 0.3% m-o-m and 6.0% y-o-y.

For the U.S. dollar to take a significant hit, we would need to see a material directional improvement in inflation readings. An in-line print or modest decline may not be enough to alter the Fed’s hiking plans or weaken its “higher-for-longer” resolve in terms of interest rates, a situation that will likely buoy U.S. Treasury yields or, at the very least, keep them from correcting lower.

On the other hand, if CPI surprises to the downside in a meaningful way, with price pressures easing across most components beyond energy, traders could start discounting a shallower tightening cycle, slowly resurrecting the "dovish pivot" theory for 2023. This scenario could undermine the greenback considering its overbought condition, paving the way for USD/CAD to begin a steep decline, especially if market sentiment also brightens in response to the data.

USD/CAD DAILY CHART

USD/CAD chart prepared using TradingView

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---Written by Diego Colman, Market Strategist for DailyFX