Canadian Dollar weakens as safe-haven demand supports US Dollar

• USD/CAD rises as uncertainty around Federal Reserve rate hikes tempers broader market sentiment.
• Shipping restrictions in the Strait of Hormuz continue to drive global energy prices higher.
• Rising crude prices increase dollar inflows into Canada, providing fundamental support to the Canadian Dollar.

USD/CAD extends its gains for the second successive day, trading around 1.4020 during the Asian hours on Friday. The pair continues to gain ground as the US Dollar (USD) benefits from revived safe-haven demand.

Tensions in the Strait of Hormuz have unsettled global markets and cast fresh doubt over efforts to fully reopen the vital shipping route. Market participants remain highly skeptical about the corridor's prospective opening, especially as Iran’s parliament reviews a draft agreement. The proposed draft would bar United States (US) and Israeli vessels, impose 20% cargo penalties on hostile nations, and keep the trade route restricted until the U.S. blockade is lifted.

Meanwhile, rising US Treasury yields and rebounding oil prices have reignited concerns that the Federal Reserve (Fed) could raise interest rates next month. Hawkish comments from Federal Open Market Committee (FOMC) members were reinforced by reports indicating that Fed Chair Warsh is prepared to hike rates if inflation accelerates further.

Musalem flags upside inflation risks while backing incremental Fed tightening

Fed’s Musalem delivered a moderately more hawkish tone, with a 7.4/10 FXS Speechtracker score relative to the historical average of 7/10, underscoring concern that inflation expectations risk losing anchor even as Musalem judges them currently stable and aligned with the 2% target. The emphasis on core inflation amid energy volatility, a preference for incremental rate hikes, and the view that inflation is more likely to stay above target, alongside the assertion that the Dollar’s reserve status remains secure and financial conditions are still highly accommodative, collectively point to a bias toward further tightening and a willingness for the central bank to occasionally surprise markets.

The FXS Fed Sentiment Index was unchanged, moving 0.00 points to a still-elevated 138.69, signaling that despite the lack of incremental shift, Fed rhetoric remains firmly in hawkish territory. The combination of a slightly above-baseline FXS Speechtracker score and a high FXS Fed Sentiment Index level suggests that markets should continue to price a risk of additional rate hikes rather than an imminent pivot toward easing.

Nevertheless, the CME FedWatch Tool shows that markets are currently pricing in a 54.5% chance of a 25-basis-point rate hike in September, down from 63.4% a week ago. Traders now await the closely watched July Nonfarm Payrolls (NFP) report for key insights into labor market conditions and the Fed's future policy trajectory.

Despite these bullish factors for the Greenback, the upside for the USD/CAD pair may remain constrained. As one of the world's largest crude exporters, Canada earns substantial US Dollar inflows when energy prices climb, providing fundamental support to the commodity-linked Canadian Dollar (CAD).

Positioning shifts as Dollar longs meet heavy Euro, Yen and Canadian Dollar shorts

Societe Generale points out that recent positioning has been heavily skewed, noting that “just as the market was long USD, so it was short other currencies – notably, the Euro, the Yen and Canadian Dollar.” This highlights a broader pattern of investors crowding into Dollar strength while simultaneously building sizeable short exposure in key counterparts, including the Euro, Yen and Canadian Dollar.