The Canadian dollar is holding near a four-week high, supported by a softer US dollar and growing expectations that the Bank of Canada will raise interest rates at its next meeting. The loonie, as the currency is commonly known, has traded around 1.4050 per US dollar after touching 1.4030 earlier this week.
Markets are now pricing in roughly an 80% chance that the central bank will lift its benchmark rate by 25 basis points to 2.50% on October 28. That would mark another step in the Bank of Canada's campaign to cool inflation, which has been stubbornly elevated partly due to high crude oil and fuel prices.
Why the loonie is firm
The currency's strength comes from a combination of factors. The US dollar has eased recently, giving the Canadian dollar room to appreciate. At the same time, Bank of Canada Governor Tiff Macklem has signaled that the central bank may raise its inflation forecast, a more hawkish tone that tends to support a currency because it suggests higher interest rates ahead.
Higher rates make a currency more attractive to investors, as they can earn better returns on Canadian assets. That dynamic has helped the loonie stay near its recent peak even as some headwinds persist.
Oil prices, a key driver for Canada's commodity-heavy economy, have slipped recently. Canada is a major oil exporter, so weaker crude can weigh on the currency. Trade friction with the United States also remains a risk, particularly for export-heavy sectors that rely on cross-border demand.
What a rate hike would mean for borrowers
For everyday Canadians, the most immediate impact of a Bank of Canada rate hike would be felt through variable borrowing costs. When the central bank raises its benchmark rate, commercial banks typically pass that through to their prime rate, which is the basis for many variable-rate mortgages and home equity lines of credit. If the widely expected hike happens on October 28, borrowers on floating rates are likely to see their interest charges rise quickly.
Fixed-rate mortgages work differently. Lenders usually price those off longer-dated government bond yields, not just one central bank decision. That is why the recent easing in Canada's 10-year government yield, which slipped to 3.867%, can help cushion fixed-rate pricing even as overnight rates edge higher. In other words, the path for fixed-rate borrowers may not move in lockstep with the Bank of Canada's policy rate.
This divergence is worth watching. While short-term rates are expected to climb, longer-term borrowing costs are not necessarily rising in step, which could offer some relief to those locking in fixed terms.
What to watch next
Investors and economists will get a fresh read on the Canadian consumer on Friday, when August retail sales data are released. That report will show whether household demand is holding up as interest rates remain restrictive. A strong number could reinforce the case for a hike, while a weak one might give the central bank pause.
The broader picture is mixed. On one hand, a hawkish central bank and a softer US dollar are supporting the loonie. On the other, falling oil prices and trade tensions with the US could cap further gains. The currency's near-term direction may hinge on the retail sales data and any new signals from the Bank of Canada in the days leading up to its decision.
For investors, the key takeaway is that the Canadian dollar's strength reflects expectations of tighter monetary policy. That has implications not just for currency traders but for anyone with debt tied to variable rates, as well as for companies that earn revenue in US dollars or rely on exports. As always, the central bank's decision on October 28 will be the main event, and the retail sales report offers a preview of the economic backdrop.
Related reading: Canadian mortgage borrowing cools ahead of possible hike and TSX gains as yields slide.
