Key Takeaways
- The Canadian dollar could continue to rise, but risks remain in trade, monetary policy, and economic growth on both sides of the border.
- The loonie’s recent strength is primarily driven by US dollar weakness.
- The outcome of the cross-border treaty negotiations could have a meaningful impact on the Canadian dollar.
The Canadian dollar has shown some surprise strength against its US counterpart, but currency watchers say there are risks that add uncertainty to the outlook.
Currency analysts see much of the strength in the Canadian dollar as a function of weakness on the US dollar’s side. Sentiment around the US dollar turned bearish over the past year, fueled by fears of dedollarization—a process whereby countries, central banks, and global markets pare their exposure to the currency.
While US dollar weakness could support continued gains in the value of the Canadian dollar, risks to that outlook range from the outcome of US-Canada free trade discussions to monetary policy divergence between the United States and Canada. There are also possible geopolitical developments, such as armed conflicts that stoke uncertainty and strengthen the US dollar. Additionally, the Canadian dollar is closely tied to the health of the domestic economy.
The US Supreme Court quashed the bulk of President Donald Trump’s steep reciprocal tariffs in its Friday ruling. However, economists aren’t expecting the decision to offer much reprieve, saying the US could use other means to tariff Canadians exports. Indeed, soon after the Supreme Court ruling, Trump announced a 10% global tariff on top of existing duties.
The push and pull of these dynamics implies the loonie’s path ”is unlikely to be linear,” according to Shirley Huang, senior analyst, global fixed income and currencies at RBC Global Asset Management. “Trade policy and CUSMA [Canada-United States-Mexico Agreement] negotiations introduce material risks that could cause the Loonie to experience higher-than-average volatility for the first half of the year,” she says.
The US Dollar Retreat Drove Up the Loonie
The Canadian dollar started the year at C$1.37 against the US dollar, and was trading at C$1.36 as of Feb. 20, having gained about 0.25% since the start of the year. Analysts generally agree on US dollar weakness being the primary driver of the Canadian dollar.
“None of the decline in USD/CAD was driven by made in Canada events,” says Sarah Ying, head of foreign exchange strategy at CIBC Capital Markets. “The greenback materially weakened into the end of January as Wall Street’s most favorite trades were unwound. This includes gold, silver, tech stocks, and bitcoin.” Unwinding of trades occur when investors sharply pare or fully eliminate their exposure to certain types of assets during a particularly volatile period.
The US currency continues to bear the brunt of the damage from unpredictable US policymaking, says Ying, who adds that the so-called “sell America” trade caused a spike in market volatility. This sparked heavy hedging, meaning investors are aggressively using financial instruments like forward contracts or
US President Donald Trump saying he supported a weaker dollar further reinforced the investor flight, according to RBC’s Huang.
Philip Petursson, chief investment strategist at IG Wealth Management, points out that the traditional drivers of the USD/CAD exchange rate—the interest rate differential between the US and Canada, as well as oil prices—appear to have taken a backseat.
Historically, when the US Federal Reserve raises or maintains higher interest rates than the Bank of Canada, the US dollar typically strengthens against the Canadian dollar. Conversely, when the rate gap narrows, the Canadian dollar appreciates. However, this year, the exchange rate is primarily driven by “a broader negative bias toward the US dollar, rather than a materially more hawkish Bank of Canada,” Petursson says.
The Contrarian View
Erik Bregar, director of FX and precious metals risk management at Silver Gold Bull, doesn’t see the Canadian dollar continuing its momentum against its US counterpart. For one, “the ‘sell America’ narrative in FX markets is irrational, and I think the strong demand we’ve seen for US bonds since the start of February proves that point,” he says.
In any case, he says that, being a volatility-sensitive asset, the Canadian dollar isn’t the currency of choice during times of volatility. In the context of the recent precipitous selloff in stock and crypto markets, Bregar says, “You don’t want to be betting the Canadian dollar will rise if the stock market takes a dive, because it’s traditionally risk-sensitive.”
CUSMA Could Clip Canadian Dollar’s Wings
CIBC’s Ying says the Canadian dollar will see some weakness in the first half of the year, underpinned by cross-border trade policy risk. “There is a lot of uncertainty around the United States-Mexico-Canada Agreement and what could happen to this trade agreement at the mandatory review on July 1,” she says. Until then, she forecasts the loonie could float within the C$1.36-C$1.39 range.
RBC’s Huang says a quick renewal of the trade deal would be quite supportive, but if the talks hit a snag, things could deteriorate. “Trade policy and CUSMA negotiations introduce material risks that could cause the loonie to experience higher-than-average volatility for the first half of the year,” he says.
Central Bank Policies to Dominate the Second Half
The monetary policy differential between the central banks on each side of the border also influences their respective currencies, says IG Wealth’s Petursson. “The key themes for loonie watchers to pay attention to include the policy path for the [US] Fed and the Bank of Canada, US fiscal and trade policy dynamics, and whether the [policy] rate-differential relationship fully breaks down or reasserts itself,” he says. “We are watching for the extent and timing of Fed rate cuts, as they could influence the USD’s direction. Similarly, the CAD would see additional support if the Bank of Canada remains on hold while the Fed continues to ease.”
CIBC’s Ying sees a loonie rebound in the second half of the year and a softer US dollar “as the Fed gradually eases interest rates.” By the second half of the year, she says the Bank of Canada might begin its next hiking cycle, since its current rate is at the lower bound of the Bank’s neutral range of 2.25%-3.25%. The neutral rate is a theoretical marker at which monetary policy neither stimulates nor restricts the economy. Ying says the policy divergence will encourage USD/CAD to trade lower in the second half of the year, strengthening the Canadian dollar.
On the other hand, a negative turn could amplify risks. “The worst-case scenario,” RBC’s Huang says, “could involve a more hawkish Fed that remains on hold or hikes rates while trade negotiations sour.” Such a scenario could create a drag on the Canadian dollar.
Watch Commodities and Currency Flows
Huang highlights that a sharp decline in commodity prices could impact trade and amplify downward pressure on the Canadian dollar, as would softer household consumption.
Silver Gold Bull’s Bregar says shifts in currency flows, as well as stock and bond market moves offer the clearest cues on the currency direction.
The loonie’s main directional drivers are “broader USD flows (how the euro and Japanese yen trade versus the USD), the broader risk mood (how the S&P 500 performs), and, occasionally, the 2-year US/Canadian yield spread,” he says.
A larger yield gap between the two bonds supports the US dollar, while its narrowing helps the Canadian dollar.
If US interest rates stay higher for longer compared to Canada’s, the US dollar would remain strong and more attractive to currency investors, relative to its Canadian peer, causing the latter to edge lower, Bregar says.
“But the opposite can occur too,” he adds. “Lower short-term US rates relative to Canadian rates would make CAD more attractive, all else being equal.”
Best-and Worst-Case Scenarios for the Canadian Dollar
CIBC’s Ying says that if dedollarization concerns continue to mount, the Canadian dollar could grind higher to C$1.32 against its US peer. However, a “terrible USMCA [United States-Mexico-Canada Agreement] outcome” could sink it back to C$1.41.
RBC’s Huang says the loonie could rise and fall between the C$1.25 and C$1.41 range.
Tom Nakamura, head of fixed income & currencies at AGF Investments, forecasts that the Canadian dollar could hit C$1.30 this year provided “global growth remains robust while the US economy softens (allowing the Fed to cut rates a few times this year), free-trade treaty is refreshed with good terms for another 16 years.” He says that in the worst-case scenario of further damage to US-Canada relations, global growth concerns, and/or inflation pressure in the US preventing the Fed from cutting rates, the US dollar rebounds and pounds the loonie back to C$1.45.
