Is the Decline of the Canadian Dollar Set to Persist?

With the Bank of Canada aggressively cutting interest rates, the Canadian dollar has cratered to a 12-week low against the US dollar—a trend market watchers say could continue if further rate cuts are on the horizon.

Following the central bank’s half-point rate cut, the loonie tumbled sharply from US$0.74, or C$1.3577, to US$0.72, or C$1.3872—its weakest level since the first week of August. The decline reflects a broader market sentiment that the policymakers’ stance on monetary easing may remain more aggressive than initially expected.

The impact of these moves extends beyond the immediate dip, which made the Canadian dollar the only Group of 10 currency to falter against the greenback. Currency strategists suggest the loonie’s slide might persist if the Bank of Canada signals openness to cuts (including one in December) in increments larger than 25 basis points. Moreover, given the macroeconomic environment—ongoing economic malaise, along with unemployment and inflation numbers—currency experts note that it may be a while before the loonie bucks its downward streak.

The risk of further depreciation has prompted some money managers to assess the implications of the Bank of Canada’s decision for the economy, inflation control, and Canadian investment portfolios. But for investors with non-Canadian holdings, a continued decline could offer a short-term boost to returns.

Bank of Canada Rate Cuts and the Dollar

The Canadian dollar’s most recent high, C$1.21 against the US dollar, came in May 2021. Since then, it has steadily weakened, hitting a low of C$1.39 against the US dollar on Oct. 31.

Dustin Reid, chief fixed-income strategist at Mackenzie Investments, says beyond the short-term dent caused by the size of the recent rate cut, “the value of the Canadian dollar will depend significantly on how far the Bank of Canada will ease rates and how long they are held at the cyclical low, particularly compared with the US Federal Reserve.”

An important variable is the so-called carry trade, a strategy employed by hedge funds and other professional investors of borrowing at a low interest rate and reinvesting in a currency or financial product with a higher rate of return. As a result of the recent dip in the loonie, “carry [trade] strategies will find the Canadian dollar less appealing,” says Tom Nakamura, currency strategist and co-head of fixed income at AGF Investments.

Things can worsen if “other central banks prove to be less dovish, or if the Canadian economic data is poor enough for a more aggressive and deeper rate cut cycle to be priced in,” Nakamura cautions. In the long term, however, he thinks a sustainable economic trajectory and the Canadian economy’s competitiveness will matter more.

Why the Loonie Could Continue to Weaken

A key threat to the Canadian dollar against the US dollar is the possibility of the Bank of Canada holding a more dovish stance than the US Fed. Reid notes that if the US economy continues to grow strongly, the Fed may not find it necessary to cut rates as much as the market believes.

Recession is another factor. If the Canadian economy can avoid a recession or suffer only a mild one, the loonie’s underperformance could be short-lived. “However, if the risks tilt more heavily toward a deeper and more painful recession, the Canadian dollar is likely to depreciate more significantly,” warns Nakamura.

Ultimately, if monetary policy can help cushion the blow and lay a path for a sustainable recovery, the Canadian dollar’s slide can be stemmed. Reid says the Bank of Canada is acutely aware of the impact its easing cycle will have on the value of the dollar and it will “likely not let it run away materially lower.”

Inflation Expectations and Currency Volatility

If the markets feel Canadian officials are too aggressive when easing monetary policy, “inflation expectations might build, the bond curve would steepen, and uncertainty would rise,” says Nakamura. He says such a scenario would further fuel Canadian dollar volatility.

Reid asserts that the central bank is early in its rate-easing cycle and that inflation expectations are not materially growing because of the Bank of Canada’s recent cut. “With the Canadian headline consumer price index at 1.6% year over year, with some downward momentum, the risks around an immediate inflation resurgence appear to be low,” he says.

The exchange rate with the US dollar has floated in the C$1.34-C$1.38 range for most of 2024, only recently surpassing the top end following the Bank’s half-point rate cut. For that reason, Reid cautions that there’s now an expectation that the Canadian dollar might see heightened volatility over the next year.

Assets Most Vulnerable and Best Positioned

A weaker currency is typically not a strong long-term macro indicator of global confidence in a country’s economic health. “A persistently weaker Canadian dollar, measured in years, would likely lead to less foreign direct investment in Canada, and by extension, a longer-term erosion of Canada’s economy with less ability to invest in R&D and fixed assets,” explains Reid.

More immediately, he says financial instruments may flow away from Canadian-dollar-denominated assets into US-dollar-denominated securities, “considering the global environment, US economic exceptionalism, and continued perceived strength in the US dollar.”

The outflow could become more intense later in the monetary easing cycle if the policy spread between the Bank of Canada and the Federal Reserve grows to 150 or 200 basis points. “Money market or cash products in Canada would be most at risk later in the cycle, given the widening interest rate spread, although there would be the US dollar or other currency risk [to consider] for the Canadian investor if they remained unhedged,” says Reid. This gap stands at 100 basis points. It will narrow in early November if the Fed lowers rates by 25 basis points.

If the Bank of Canada successfully guides the economy toward a “soft landing,” then Nakamura says, “Canadian assets are likely to benefit as economic prospects improve under an accommodative monetary policy.”

What a Weaker Dollar Means for Investors

While a significant long-term decline in a country’s currency can present inflation risks, in the short term, it can be good news for investors with non-Canadian stocks or funds in a portfolio. The value of investments in US dollars or other foreign currencies will likely increase when converted back to the domestic dollar if the latter remains weak. “This is because the local currency of the investment has appreciated and can buy more Canadian dollars when the Canadian investor repatriates the balance,” Reid explains.

However, he points out that global portfolios are often at least partially currency-hedged, which would limit or offset the impact of any currency differential caused by volatility. “Canadian investors should always ask themselves how much currency risk they want to take on their international investments,” Reid says.

A depreciated Canadian dollar may enhance short-term returns, but “global diversification remains important for broad long-term benefits, subject to individual risk tolerances and considerations,” Nakamura says.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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