Can We Expect the Canadian Dollar to Fall?

As expected, the Bank of Canada did not raise interest rates this morning, leaving the overnight rate at 2.5 percent. This is significant, as the Federal Reserve has been steadily increasing rates in the United States; the latest of which on December 14th sent the Federal Funds rate, America's benchmark interest rate, to 2.25 percent. Forecasters expect American rates to keep rising, as the Federal Funds rate has already almost doubled in the last 6 months. This is significant, as history shows us that the "interest rate gap", the difference in interest rates between Canada and the United States, has a great deal of influence on the value of the Canadian dollar relative to the greenback. If American rates keep rising while Canadian ones stay flat, expect to see the Canadian dollar fall in value.

A fall in the Canadian Dollar is already starting to take place. In the few hours after the announcement, the Canadian dollar fell nearly a full cent and hovered under 81 cents U.S. during the day. Could we see a return to the dynamics of the early 1990s with a falling Canadian dollar, as discussed in "A Beginner's Guide to Exchange Rates"?

At the beginning of the 1990s, interest rates in Canada were over 4 percentage points higher than in the United States, and the Canadian dollar was worth nearly 90 U.S. cents. During this time Bank of Canada Governor John Crow embarked on a mission to slay the two double dragons of high interest rates and high inflation. The policies put into place by Crow and his successor Gordon Thiessen worked well; by January 1997 Canadian interest rates were over 3 percentage points lower than in the United States. The currency, however, paid a terrible price, falling down to 70 cents U.S. It would be further reduced in value by the Asian crisis of 1997-1998.

Why does changes the interest rate gap impact exchange rates? The mechanism is relatively straight-forward. Investors in interest-bearing securities such as bonds want to get the highest return possible. So when interest rates are high in a country, such as Canada, they will wish to purchase Canadian bonds. But in order to purchase Canadian bonds, they need Canadian dollars. So they will go to a foreign exchange market, trade their currency for Canadian dollars, thus causing the value of the Canadian Dollar to go up.

During the 1990s, Canadian interest rates went down relative to U.S. ones, making Canadian bonds less attractive to investors than their U.S. counterparts. So investors sold their Canadian bonds and bought American ones. In order to do this they needed to sell their Canadian dollars on the market and purchase U.S. ones, causing the value of the Canadian dollar to fall.

With this announcement today, Canada is on the path to a devalued Canadian dollar, particularly if the United States continues to raise their interest rates. Certainly there are many other factors which impact the value of a currency, but the interest rate gap is an important one.

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