The Canadian Dollar is likely to rise as a result of recent hawkish commentary from Bank of Canada (BOC).

Canadian interest rates, set by the BOC, are currently at a record low 0.50% but recent statements by BOC officials including governor Poloz and deputy governor Carolyn A Wilkins suggested they were gearing up to raise base lending rates in the near future.

Increasing interest rates usually has a positive effect on a currency as it increases capital inflows because investors prefer sending their money to where they can get a higher return.

Analysts at Bank of America Merrill Lynch Global Research (BofA) have analysed the relationship between the two variables over time and note how in the last few years the impact of changing interest rates on the Canadian Dollar has grown.

The chart below represents the results of research BofA conducted into the relationship between the US and Canadian interest rate differential and the US Dollar Canadian Dollar exchange rate.

The line shows the coefficient, which is the factor by which the interest rate influences the exchange rate.

When the coefficient is zero the relationship is proportional, which means a certain basis point move in the interest rate, or difference in US/Canadian interest rates – say 10 - would have a similar impact on the exchange rate – say 50 pips.

However, lately the coefficient has shot up, showing that the same move in interest rates would have a greater impact on the exchange rate by a factor represented by the rising coefficient – which in this case peaked at 0.14 in late 2016.

In our theoretical example above, the 10 basis point rate move would have had a 1.14 times greater impact on the currency when the coefficient was at its peak at the end of 2016 moving it 57 pips rather than the 50 previously when the coefficient was at, or around, zero.

Raising the CAD Profile But Still a Little Skeptical

Despite this, however, BofA’s Strategist Alex Shin, is still sceptical as to whether these gains can be held on to.

“But we see CAD as somewhat overvalued, especially in light of the recent moves in oil as well, and expect a higher USD-CAD at the end of the year, to 1.35, which is still lower than our previous forecast of 1.39,” said Shin.

The weakening in the price of oil, is therefore, expected to offset gains in from higher interest rates.

Oil is a major export of Canada so any devaluation affects demand for CAD quantitatively, however, a fall in oil prices also influences inflation, by reducing energy costs.

Lower energy bills should keep inflation down which in turn is likely to limit the number of interest rate hikes by the BOC.

“In particular, such expectations of a rate hike feel at odds with some fundamentals, giving the additional power to impact the currency through a surprise factor. The Bank of Canada, who watches their 2% inflation target closely, is missing their target to the downside across the board. Not only has headline inflation fallen toward 1%, but core inflation measures are now also closer to 1% as well,” commented Shin.

BofA’s economics team expects a hike at the July 2017 BOC meeting, or if not then, then on October the 25th.

This has led the strategy team to downgrade their end of year forecasts from 1.39 to 1.35, as they see a potentially deeper correction lower around the time of the rate rise, either in the summer or October.