Canadian Dollar holds steady as Middle East risks, BoC policy uncertainty cap moves

• USD/CAD trades around 1.3950 on Tuesday, virtually unchanged on the day after reaching a two-month high of 1.3961 on Monday.
• Investors remain cautious despite the de-escalation between Iran and Israel, as geopolitical tensions in the Middle East continue to support risk aversion.
• The Bank of Canada is widely expected to keep its policy rate unchanged at 2.25% on Wednesday amid mixed signals from the Canadian economy.

USD/CAD trades around 1.3950 on Tuesday at the time of writing after snapping a four-day winning streak. The pair is pulling back slightly after reaching a two-month high of 1.3961 on Monday, as the US Dollar (USD) gives back part of its recent gains and investors adjust positions ahead of the Bank of Canada (BoC) monetary policy decision.

Market sentiment improved after Iran and Israel agreed to halt mutual attacks following an appeal from US President Donald Trump. The de-escalation reduced safe-haven demand and limited support for the Greenback. However, caution remains elevated. According to several media reports, the Israeli military ordered the immediate evacuation of parts of the Lebanese city of Tyre ahead of potential strikes, while Israeli Prime Minister Benjamin Netanyahu stated that the conflict with Iran and Hezbollah “has not yet ended.”

On the US side, markets continue to assess the outlook for Federal Reserve (Fed) policy. Strong US labor market data released recently have reignited inflation concerns and boosted expectations of additional monetary tightening. According to the CME FedWatch tool, the chance of a 25-basis-point rate hike in December has risen to 43%, up from just 14% a month ago. Upcoming Consumer Price Index (CPI) data on Wednesday and Producer Price Index (PPI) figures on Thursday are expected to provide further clues on the Fed’s policy path.

The Canadian Dollar (CAD) remains caught between several fundamental drivers. Recent weakness in Oil prices continues to weigh on the currency, as Canada remains one of the largest energy exporters to the United States (US). At the same time, major financial institutions offer mixed assessments of the Canadian economic outlook.

Rabobank argues that the economy remains fragile after two consecutive quarters of Gross Domestic Product (GDP) contraction, highlighting the negative impact of trade tensions with the US and weak investment activity. In contrast, RBC believes recent GDP figures overstate economic weakness due to the exceptional decline in population growth and sees Canada as being in the early stages of an economic recovery.

Attention now turns to Wednesday’s Bank of Canada policy announcement. Markets overwhelmingly expect the central bank to leave its policy rate unchanged at 2.25%. Rabobank also expects rates to remain at that level through year-end, arguing that policymakers are facing conflicting forces between energy-driven inflation risks and economic weakness stemming from external trade uncertainties.