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- CAD gains sharply in overnight session after oil spikes 10%.

- Attack on Saudi oil field switches off 6% of global production.

- Stokes fears of confrontation in Gulf after Iran seen in frame.

- Comes ahead of crunch Fed decision tipped as key for CAD.

The Canadian Dollar strengthened Monday following a spike in the oil price that was brought on by a drone attack on a Saudi Arabian oil facility, although analysts say it could rise further this week if oil prices continue to climb.

Saudi Arabia's Abqaiq processing facility and the Khurais oilfield were attacked by drones over the weekend leading to fires that have sidelined around 5.7 mn barrels of oil that would otherwise have been pumped by Saudi Aramco on a daily basis. Amin Hassan Al-Nasser, chief executive officer at Saudi Aramco, told the Saudi Press Agency there were no injuries caused by the attack but that it could take some days to restore production, which is equivalent to nearly 6% of global supply, to earlier levels.

President Donald Trump said the U.S. would open its strategic reserves in order to plug any supply deficit over the coming weeks. He has frequently hit out in the past at the Organization for Petroleum Exporting Countries (OPEC) over high oil prices, which can lift inflation and surpress economic growth, even in producer countries, because it's 'volumes' rather than the value of barrels sold that matter in the calculation of GDP. Currencies benefit from higher prices through the 'terms of trade'.

Saudi Arabia oil supply was attacked. There is reason to believe that we know the culprit, are locked and loaded depending on verification, but are waiting to hear from the Kingdom as to who they believe was the cause of this attack, and under what terms we would proceed!

— Donald J. Trump (@realDonaldTrump) September 15, 2019

Above: Global oil production estimates and forecasts from U.S. Energy Information Administration.

"Expect a bout of short covering come market open on Monday, but the degree to which prices move higher will be dependent on fresh investor length since short interest in WTI has been relatively low and largely sidelined since the summer when drone strikes and tanker seizures heated up," says Michael Tran, a commodity strategist at RBC Capital Markets. "The pace and magnitude of the forthcoming price action will be dependent on the return of the wounded bulls."

Brent crude oil futures prices hit $68.38 during the overnight session, a difference of more than 13% from Friday's close, before paring gains to trade only 8.3% higher into the European morning. Prices of WTI crude, the North American benchmark, were 7.5% Monday. Gains in oil prices are often positive for the Canadian Dollar although they only tend to benefit the economy if and when they lead to more barrels of oil being sold.

"USD/CAD should settle to the 1.3150-1.3220 range while EUR/NOK should drift towards the 9.85-9.90 range," says Bipan Rai, head of FX strategy at CIBC Capital Markets. "Importantly, USD/CAD would still be above our targeted entry into fresh long positions at the 1.3050/75 area. Only a break below there would lead us to conclude that our strategic long USD/CAD bias is wrong."

Above: CIBC estimates of USD/CAD returns for selected oil price changes.

"There are three questions following the drone attacks on Saudi oil installations: How fast can supply recover, can further attacks be prevented, and what will the wider geopolitical implications be?," says Kit Juckes, chief FX strategist at Societe Generale. "There is bound to be a higher risk premium attached to prices going forwards. Slower global growth was beginning to act as a drag on oil prices, but the risk premium goes the other way and that in turn is another drag on global growth."

The USD/CAD rate was quoted 0.17% lower at 1.3259 during the morning session Monday, after dipping as low as 1.3207 overnight as the Loonie surged, and is now down 2.49% for 2019. The Pound-to-Canadian-Dollar rate was 0.30% lower at 1.6536 Monday after falling as low as 1.6440 overnight and is now down 4.97% for 2019. The Canadian Dollar remains the best performing major currency of 2019.

"The rebound in US yields has prompted a widening in short-term US-Canada spreads (lifting the 2Y spread to 13bps as of last night, up around 10bps from the recent low). We remain generally constructive on the outlook for the CAD and still rather favour fading near-term weakness but markets may settle into a range now as investors cast an eye towards [the] FOMC meeting," says Shaun Osborne, chief FX strategist at Scotiabank.

Above: USD/CAD rate shown at hourly intervals.

Monday's price action comes at the beginning of what will be a big week for currency markets, with investors eyeing the Federal Reserve (Fed) interest rate decision due at 19:00 Wednesday for cues on exchange rates into year-end. The Fed is widely expected to reduce its interest rate by at least 25 basis points to 2% but investors are also looking for guidance on the bank's next likely steps on monetary policy.

"With only two more decision dates left this year, the end-of-2019 dot shows you the Fed’s current thinking on decisions that they will face in the very near future," says Avery Shenfeld, chief economist at CIBC. "The median forecast for the end of the year has a fair chance of coming to fruition, and we expect that dot to allow for one more 25 basis point easing after September. Further out...forget it."

With the U.S.-China trade war having ravaged the global economy, central banks the world over have beat a retreat from earlier hawkish guidance that suggested they were once likely to raise their own interest rates. That's left the Fed and the Bank of Canada (BoC) cash rates of 2.25% and 1.75% respectively looking appealing to many international investors, particularly as their economies have shown resilience to the ongoing global economic slowdown.

Above: Pound-to-Canadian-Dollar rate shown at hourly intervals.

The trade war is now seen catching up with the U.S. economy over the coming months and both the markets as well as President Donald Trump are demanding action from the Fed in their own ways. If the Fed indulges those demands, which are for another three rate cuts before the end of March 2020, the Dollar could find itself steadily being undermined against many other currencies but particularly the Canadian Dollar because the BoC is not expected to begin reducing its own rate until December.

"We think there is a high risk the FOMC signals a pause in its “mid‑cycle adjustment”. Of interest will be how many further rate cuts to the Fed funds rate are published in the FOMC’s ‘dot plots’. What will be certain, is the large disparity of FOMC member views on the need for further rate cuts," says Richard Grace, head of FX strategy at Commonwealth Bank of Australia. "USD would lift if the Fed signals a pause in its “mid‑cycle adjustment”. At the very least, we would anticipate a knee jerk reaction. However, we do not expect a large lift in the USD to last long. The more optimistic the FOMC is about the US economy, the more optimistic market participants should be about the global economic outlook. The USD usually falls amidst optimism about the global economic outlook."

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