A Staff Analytical Note on Monetary Policy, Interest Rates and the Canadian Dollar, which was released this February by the Bank of Canada, examined recent monetary developments and their effects on the Canadian dollar.
According to this note, recent divergent monetary policies, with U.S. rates remaining high while Canadian rates drop, have contributed to the depreciation of the Canadian dollar, partly due to an added risk premium amid global uncertainty. However, while these short-term factors are influential, the currency’s long-term value will ultimately be determined by slower-moving fundamentals such as productivity, economic structure, fiscal policies, and long-run inflation trends.
Diverging Interest Rates
In 2024, Canada and the United States began following different monetary paths. Although both countries started with similar policy rates, expectations soon shifted. U.S. rates are expected to remain high while Canadian rates are forecast to drop. By the end of 2025, estimates indicate Canadian rates might be around 2.5 to 2.6% compared to roughly 3.75 to 3.92% in the U.S., which reflects a divergence of more than 1 percentage point.
Exchange Rate Impact
The gap in interest rates contributed to a significant depreciation of the Canadian dollar. In 2024, the Canadian dollar fell by about 7.7% against the U.S. dollar, even more than the interest rate gap alone would suggest. This extra depreciation is driven by a risk premium, where investors demand higher compensation for perceived risks in international markets. For investors, a weaker Canadian dollar can influence the cost of foreign investment and the value of cross-border returns.
Risk Premium and Market Uncertainty
Global uncertainty and volatile international trade have increased the risk premium embedded in the exchange rate. This means that, beyond interest rate differences, there is extra pressure on the Canadian dollar due to market concerns.
Historical Context and Future Outlook
Historically, differences between U.S. and Canadian interest rate paths have tended to fade over time as major risks and uncertainties are resolved. In the long run, other factors which are typically slow-moving and hard to detect play a greater role in determining currency value:
Productivity and the composition of real economic activity
Fiscal and trade policies
Long-run inflation rates
The most significant recent fluctuation in the Canadian dollar occurred in two phases between 2004 and 2014 (excluding the 2008–09 global financial crisis). From 2004 to 2008, the Canadian dollar appreciated from 70 cents to US$1, while from 2013 to 2015, the Canadian dollar depreciated from US$1 to around 75 cents.
In both cases, the magnitude of the swings exceeded what could be explained by policy divergence or changes in the exchange rate risk premium. Such large movements require shifts in fundamental factors like differences in productivity, economic structure, and other long-term characteristics of each economy.
The swings from 2004 to 2014 highlight the importance of these factors. During this period, significant foreign investment in Canada’s oil and gas sector boosted gross capital formation and led to innovations that reduced extraction costs. This change, not yet seen in the United States, improved Canada’s terms of trade and strengthened the Canadian dollar over several years.
While financial market prices and forecasters’ surveys indicate a persistent gap between Canadian and U.S. policy interest rates, which will continue to affect the Canadian dollar, the impact is expected to be modest, according to the BOC’s Staff Analytical Note.
Currently, foreign investors’ risk compensation plays a larger role in weakening the Canadian dollar. Additionally, structural changes, such as accelerated investment and productivity growth in the United States, may further strengthen the U.S. dollar against currencies like the Canadian dollar. Monitoring these long-term factors is critical to understanding the future trajectory of the Canadian dollar.