USD/CAD trades near five-month lows as BoC-Fed policy divergence favours the Loonie
- USD/CAD trades near five-month lows as holiday-thinned markets limit volatility.
- The Canadian Dollar finds support from a widening policy divergence between the BoC and the Fed.
- Markets see the BoC holding rates through 2026, while the Fed is expected to ease gradually.
The Canadian Dollar (CAD) holds modest gains against the US Dollar (USD) on Wednesday, even as the Greenback trades firm amid limited movement as markets drift into holiday mode. At the time of writing, USD/CAD is trading around 1.3675, hovering near its lowest level since July 25.
Gross Domestic Product (GDP) data released on Tuesday did little to shift sentiment around USD/CAD. Canada’s economy contracted by 0.3% MoM in October, matching forecasts and reversing a 0.2% gain in the prior month. Meanwhile, the preliminary estimate of third-quarter GDP showed the US economy grew at a strong annualised pace of 4.3%, beating both the prior estimate of 3.8% and the market expectation of 3.3%.
The Loonie remains underpinned by a widening policy divergence between the Bank of Canada (BoC) and the Federal Reserve (Fed). The BoC kept its policy rate unchanged at 2.25% at its December meeting and signalled comfort with its current policy stance, saying current settings are appropriate to support the economy while keeping inflation close to the 2% target.
Markets have largely interpreted the decision as marking the end of the BoC’s easing cycle, following a cumulative 100 basis points (bps) of rate cuts since the beginning of the year. In its latest meeting minutes, Governing Council members acknowledged that uncertainty remains elevated and discussed whether the next policy move would be a hike or a cut. While officials agreed that the current policy rate is “about right” for now, they stressed that the timing and direction of the next adjustment remain difficult to predict.
That said, the base-case view is for the BoC to keep the policy rate around 2.25% through most of next year, with some upside risk that the next move could be a hike in the second half of 2026.
In contrast, the Fed is seen moving along a more gradual easing path. Markets expect further monetary policy easing next year after the Fed delivered a total of 75 bps of rate cuts this year. However, policymakers remain divided on the need for additional cuts, citing differing views on inflation and labour market conditions.
However, markets widely expect the Fed to hold rates steady in January, with CME FedWatch pricing just a 13% chance of a cut, while still anticipating two rate cuts later in the year.
Canadian Dollar FAQs
The key factors driving the Canadian Dollar (CAD) are the level of interest rates set by the Bank of Canada (BoC), the price of Oil, Canada’s largest export, the health of its economy, inflation and the Trade Balance, which is the difference between the value of Canada’s exports versus its imports. Other factors include market sentiment – whether investors are taking on more risky assets (risk-on) or seeking safe-havens (risk-off) – with risk-on being CAD-positive. As its largest trading partner, the health of the US economy is also a key factor influencing the Canadian Dollar.
The Bank of Canada (BoC) has a significant influence on the Canadian Dollar by setting the level of interest rates that banks can lend to one another. This influences the level of interest rates for everyone. The main goal of the BoC is to maintain inflation at 1-3% by adjusting interest rates up or down. Relatively higher interest rates tend to be positive for the CAD. The Bank of Canada can also use quantitative easing and tightening to influence credit conditions, with the former CAD-negative and the latter CAD-positive.
The price of Oil is a key factor impacting the value of the Canadian Dollar. Petroleum is Canada’s biggest export, so Oil price tends to have an immediate impact on the CAD value. Generally, if Oil price rises CAD also goes up, as aggregate demand for the currency increases. The opposite is the case if the price of Oil falls. Higher Oil prices also tend to result in a greater likelihood of a positive Trade Balance, which is also supportive of the CAD.
While inflation had always traditionally been thought of as a negative factor for a currency since it lowers the value of money, the opposite has actually been the case in modern times with the relaxation of cross-border capital controls. Higher inflation tends to lead central banks to put up interest rates which attracts more capital inflows from global investors seeking a lucrative place to keep their money. This increases demand for the local currency, which in Canada’s case is the Canadian Dollar.
Macroeconomic data releases gauge the health of the economy and can have an impact on the Canadian Dollar. Indicators such as GDP, Manufacturing and Services PMIs, employment, and consumer sentiment surveys can all influence the direction of the CAD. A strong economy is good for the Canadian Dollar. Not only does it attract more foreign investment but it may encourage the Bank of Canada to put up interest rates, leading to a stronger currency. If economic data is weak, however, the CAD is likely to fall.
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