Canadian Dollar holds steady as hawkish Fed expectations anchor US Dollar

December Fed rate hike expectations are strengthening. Hotter US inflation and hawkish Fed remarks may lift USD/CAD.
The Canadian Dollar faces pressure from weaker crude prices as OPEC+ production surges and US-Iran tensions ease.
At 3.1%, rising Canadian inflation strengthens Bank of Canada rate hike expectations, limiting downward pressure on the CAD.

1.4250 is the level around which USD/CAD is holding steady in Thursday's Asian session. The pause follows two successive days of gains. Further upside remains possible, as a more hawkish Federal Reserve (Fed) policy outlook may support the US Dollar (USD).

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A stronger-than-forecast US Consumer Price Index (CPI) inflation reading has prompted traders to increase expectations for a December rate hike. Those expectations gained further traction after Fed Governor Christopher Waller said earlier this week that he would support a quarter-point rise, or even a half-point increase should inflation deteriorate. The CME FedWatch Tool now puts the market-implied probability of a December rate hike at around 87%, with a nearly 13% chance of a larger 50 basis point increase.

TD Securities sees further potential for the US Dollar to strengthen against selected major currencies. Its analysts state that “across global major currencies, we see room for the USD to rally selectively against CAD and KRW in the near-term.” Their assessment is that “diverging employment data releases will likely keep USDCAD supported above 1.40,” with Canada’s “rising unemployment rate amid falling wage growth rate” weakening the argument for tighter monetary policy. They believe this environment “reduces the market pricing of a December BoC rate hike relative to the Fed,” exposing the Canadian Dollar to weakness while supporting USDCAD at elevated levels.

Lower crude oil prices present another potential source of upside for USD/CAD by weighing on the commodity-linked Canadian Dollar (CAD). The oil market has retreated amid expanding supply and signs that the US and Iran are avoiding further escalation.

OPEC’s monthly report, published on Wednesday, showed that OPEC+ crude output reached 41.23 million barrels per day in October, a jump of roughly 2.04 million barrels per day. Increased production from Saudi Arabia accounted for much of the rise.

Potential monetary tightening at home is providing some support for the CAD, with traders also pricing in a possible Bank of Canada (BoC) rate hike. Canada’s annual inflation rate rose from 3.0% in August to 3.1% in September, its highest level since the 3.2% recorded in May. Separately, the Democratic Party's US mid-term election victory may ease trade-related pressure on Canadian economic growth.

Canadian Dollar: Key questions answered

The Canadian Dollar’s main drivers

Bank of Canada (BoC) interest rates, oil prices, economic conditions, inflation and the trade balance are central to the Canadian Dollar’s (CAD) performance. Oil is Canada’s largest export, while the trade balance measures the difference between the value of exports and imports. Investor sentiment also matters: demand for riskier assets, known as risk-on, supports the CAD, whereas risk-off sentiment reflects a preference for safe havens. Conditions in the US economy are another important influence, as the US is Canada’s largest trading partner.

Bank of Canada policy and the Canadian Dollar

By setting the interest rate at which banks lend to each other, the Bank of Canada (BoC) shapes borrowing rates across the economy and significantly influences the Canadian Dollar. Its primary objective is to keep inflation within 1-3%, raising or lowering rates to achieve that goal. Relatively high interest rates generally support the CAD. The central bank can also alter credit conditions through quantitative easing or quantitative tightening. Easing tends to weaken the CAD, while tightening tends to strengthen it.

Oil prices and the Canadian Dollar

As petroleum is Canada’s largest export, changes in oil prices tend to feed directly into the Canadian Dollar’s value. Rising oil prices generally lift the CAD by increasing overall demand for the currency; falling prices usually have the reverse effect. More expensive oil also tends to increase the likelihood of a trade surplus, providing further support for the CAD.

Inflation’s influence on the Canadian Dollar

Traditionally, inflation was regarded as harmful to a currency because it erodes purchasing power. With cross-border capital controls relaxed in modern times, however, the relationship has in fact reversed. Higher inflation typically prompts central banks to raise interest rates, drawing capital from global investors seeking attractive returns. Those inflows increase demand for the domestic currency, which in Canada is the Canadian Dollar.

Economic indicators and the Canadian Dollar

The Canadian Dollar can respond to macroeconomic releases because they indicate the economy’s health. GDP, manufacturing and services PMIs, employment figures and consumer sentiment surveys all help shape the CAD’s direction. Economic strength supports the currency by attracting foreign investment and potentially prompting the Bank of Canada to raise interest rates. Weak data, by contrast, are likely to weigh on the CAD.