Canadian Dollar struggles as US-Canada yield gap widens

• USD/CAD climbs to a fresh two-month high as the US-Canada yield gap widens.
• The Canadian Dollar remains under pressure despite a rebound in Oil prices, with traders weighing diverging Fed and BoC outlooks.
• Markets turn to Canadian GDP and key US data this week for fresh direction on USD/CAD.

USD/CAD extends its rally on Monday as diverging monetary policy outlooks between the Federal Reserve (Fed) and the Bank of Canada (BoC) keep the US Dollar (USD) favoured, outweighing support for the commodity-linked Canadian Dollar (CAD) from higher Oil prices. At the time of writing, the pair trades around 1.4165, its highest level since July 13.

Oil prices rebound as traders react to the setback in US-Iran talks. US President Donald Trump rejected Iran’s latest proposal to reopen the Strait of Hormuz, though he told Axios he expects US negotiators to hold further talks this week.

The Canadian Dollar has lost more than 2% so far this month as the US-Canada yield gap widens. The US 2-year Treasury yield trades near 4.90%, compared with around 3.37% for its Canadian counterpart. The gap between the 10-year yields is also wide, with US Treasuries near 5.21% and Canadian government bonds around 3.96%.

The Fed raised interest rates by 25 basis points (bps) at its September 15-16 meeting, lifting the federal funds rate to 3.75%-4.00%, and signalled that further tightening may be needed as policymakers work to bring inflation back toward the 2% target. Hawkish comments from Fed officials last week strengthened expectations for additional rate hikes, with markets now pricing in a 70% chance of a rate increase in October, according to CME FedWatch.

Strategists at Brown Brothers Harriman argue that the USD “can continue to benefit from widening US-G6 interest rate differentials and rising US longer-term real yields,” underpinning the currency’s recent resilience. However, they caution that “tightening by other major central banks limits policy divergence with the Fed and suggests DXY could struggle to sustain an overshoot of its June 24 high at 101.80.” Even so, Brown Brothers Harriman believes that “US economic growth outperformance and strong foreign appetite for US securities can override that upside USD constraint,” keeping the Dollar fundamentally supported despite technical headwinds for the index.

The BoC, by contrast, kept its policy rate at 2.25%, noting limited spillover from higher energy prices into broader inflation. However, the central bank said it was prepared to adjust monetary policy as needed, acknowledging that upside risks to inflation had increased while new tariffs made the growth outlook more uncertain.

Traders now turn to Canada’s July Gross Domestic Product (GDP) data on Tuesday. In the United States, the Personal Consumption Expenditures (PCE) inflation report is due Wednesday, the ISM Manufacturing Purchasing Managers’ Index (PMI) on Thursday and the Nonfarm Payrolls (NFP) report on Friday.