During Asian trading on Friday, USD/CAD extended its gains to near 1.4020, heading for a second consecutive day of increases. The flight to safety, driven by escalating geopolitical risks, is funneling capital back into the US dollar. Meanwhile, a rebound in oil prices has reignited inflation concerns, strengthening expectations for a Federal Reserve interest rate hike.

However, as one of the world's largest crude oil exporters, Canada benefits from dollar inflows due to higher oil prices, providing fundamental support for the Canadian dollar and capping the upside for USD/CAD.

Geopolitical Risks Fuel Safe-Haven Demand

The ongoing escalation of tensions in the Strait of Hormuz is severely shaking global market stability and casting fresh doubt on the prospect of the key waterway being fully reopened. Market participants remain highly skeptical about the passage through the strait, particularly as the Iranian parliament considers a draft agreement. The proposal would ban US and Israeli vessels from passing through, impose a 20% cargo fine on ships from "hostile" nations, and maintain transit restrictions until the US lifts its blockade.

Meanwhile, rising US Treasury yields and the oil price rebound have rekindled market concerns that the Fed might raise interest rates next month. Hawkish rhetoric from Federal Open Market Committee members has been reinforced, with reports suggesting that Fed Chair Kevin Warsh is prepared to hike rates if inflation accelerates further.

Musallem Releases Hawkish Signals, Solidifying Rate Hike Expectations

St. Louis Fed President Alberto Musallem released slightly hawkish signals on Thursday. His speech rating was slightly above the historical average, emphasizing the risk of inflation expectations "de-anchoring" even though they are currently aligned with the 2% target. Musallem is focusing on core inflation against the backdrop of energy volatility, leaning toward a gradual approach to rate hikes. He believes inflation is more likely to remain above the target. He also asserted that the dollar's reserve currency status is solid and that financial conditions remain highly accommodative. These views collectively point to a bias toward further tightening and a willingness by the central bank to occasionally surprise the market.

The CME FedWatch Tool shows that the market currently prices in a 54.5% probability of a 25-basis-point rate hike in September, down from 63.4% a week ago. Traders are now awaiting Friday's nonfarm payrolls report for key information on labor market conditions and the Fed's policy path.

Oil Price Rebound Provides Hedging Support for the Canadian Dollar

Despite these factors favoring the US dollar, the upside for USD/CAD may remain limited. As one of the world's largest crude oil exporters, Canada receives substantial dollar inflows when energy prices rise, providing fundamental support for the commodity-linked Canadian dollar. Crude oil prices rebounded sharply by more than 3% on Thursday to above $82 per barrel, reversing the downward trend driven by expectations of easing geopolitical tensions. Higher oil prices directly improve Canada's terms of trade, increasing buying demand for the Canadian dollar, thereby limiting the upside potential for USD/CAD. The exchange rate is caught in a tug-of-war between the strengthening safe-haven dollar and the Canadian dollar supported by oil prices.

Positioning: A Pile of Dollar Longs Coexists with Euro, Yen, and Canadian Dollar Shorts

A well-known institution noted that recent positioning is heavily skewed to one side. "Just as the market is long the US dollar, it is also shorting other currencies—especially the euro, the Japanese yen, and the Canadian dollar." This reveals a broader pattern: while investors are crowded in long dollar positions, they have also built up significant short positions in key counterpart currencies like the euro, yen, and Canadian dollar. This extreme positioning structure means that if market sentiment shifts or an unexpected catalyst emerges, the dollar could face profit-taking pressure. Meanwhile, the shorted currencies, such as the Canadian dollar, could experience a short-covering rally. This also explains why the upside for USD/CAD is relatively limited, despite the overall strength of the US dollar.

Summary

USD/CAD has recovered to near 1.4020, heading for a second consecutive day of gains. The flight to safety, driven by escalating geopolitical risks, is funneling capital back into the US dollar. The rebound in oil prices has reignited inflation concerns, strengthening expectations for a Fed rate hike. Iran's review of the Strait of Hormuz ban draft is further boosting market risk aversion, and Musallem's comments have cemented expectations that the Fed will maintain a tightening stance. However, as one of the world's largest crude oil exporters, Canada benefits from dollar inflows due to higher oil prices, providing fundamental support for the Canadian dollar and capping the upside for USD/CAD. The positioning structure shows that while the market is crowded with long dollar positions, it is also shorting the Canadian dollar, and this extreme positioning could become a potential source of future volatility. The market is now waiting for the US nonfarm payrolls report for clearer directional guidance.