Changes in interest rates can have a drastic effect on exchange rates. Investors interested in purchasing a security that pays interest, such as a bond, will buy the bond that gives them the highest interest rate, all else being equal. Since Canadian bonds had a lower interest rate than American bonds, investors were more interested in purchasing American bonds, and less interested in Canadian ones. In order to purchase American bonds, they would need to buy American dollars on the foreign exchange market, causing a reduction in the supply of U.S. dollars and a rise in their value relative to other currencies such as the Canadian one. If Canadians are buying U.S. bonds, they'll be selling Canadian dollars and buying American ones, so we'll see an increase in the supply of Canadian dollars and a decline in their value.

We should then expect to see periods where the exchange rate and the interest rate move in the same direction. Visually it would be helpful to plot them both on the same set of axes. To do this I had to perform a scaling operation on the interest rate gap. By taking the gap, dividing it by 50 then adding 0.7 to this figure, I was able to plot both on the same chart:

The exchange rate is the blue line which starts higher and the interest rate gap is the purple line which starts lower. Note how both decline until 1997. The correlation coefficient for the interest rate gap and the exchange rate from January 1990 to December 1996 is 0.73; the two were highly positively related during this period. However during the Asian crisis of 1997-1998 the two went in opposing directions and the correlation coefficient was -0.91. Changes in the interest rates gap have not gone in the same direction as changes in the exchange rate since 1998 as the correlation coefficient is -0.75. It would appear that if we're looking for reasons why the Canadian dollar may have been weak since 1998, we'll have to look elsewhere for an answer.