Canadian Dollar falls to four-week lows at 1.4230 as bets on Fed tightening strengthen the Greenback

USD/CAD climbs to a fresh four-week high of 1.4230, taking its gain to nearly 2% in under one week.
Expectations have firmed following stronger-than-forecast US inflation and robust labour market conditions, with hopes now centred on a rate increase of at least a quarter-point at the next Fed meeting.
The contrasting employment figures from the US and Canada published on Friday are likely to underpin the pair above 1.4000, according to TD Securities' analysts.

Broad-based US Dollar (USD) strength has pushed the Canadian Dollar (CAD) back into decline on Wednesday, as investors increasingly anticipate Federal Reserve (Fed) tightening in December. At the start of the US session, USD/CAD is trading at a fresh four-week high of 1.4230, having gained nearly 2% in under a week.

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The Greenback has drawn support from speculative investors since the US Bureau of Labour Statistics (BLS) reported a stronger-than-expected rise in consumer inflation for October. Alongside Friday’s robust Nonfarm Payrolls (NFP) report, the inflation figures have reinforced expectations of a rate increase of at least a quarter-point at the Fed’s December meeting.

Do Fed officials reinforce expectations of at least a quarter-point hike in December?

Comments from Fed officials late Tuesday reinforced those expectations. Philadelphia Fed President Anna Paulson signalled “further gradual tightening” ahead to return inflation to target. Dallas Fed President Lorie Logan expressed a similar view, stating that “the Fed needs at least two more quarter-percentage-point increases.”

Ahead of the US Consumer Price Index (CPI) release, Fed Governor Christopher Waller said a reading of 0.3% or more would lead him to support a 25-basis-point hike. Inflation ultimately rose 0.4%. He also added that “I believe a 50-basis-point hike in the policy rate should be considered”. According to the CME’s FedWatch Tool, futures markets have raised the probability of a jumbo December rate increase to 12%, compared with virtually none last week.

Canada presents a contrasting picture. Released at the same time as the US NFP figures, its October employment report recorded a net decline in jobs and an increase in unemployment. TD Securities analysts contend that “diverging employment data releases will likely keep USDCAD supported above 1.40,” because a “rising unemployment rate amid falling wage growth rate in Canada also reduces the market pricing of a December BoC rate hike relative to the Fed.” They believe weaker Canadian labour market conditions, alongside a relatively more hawkish Fed, should leave the Canadian Dollar under pressure for the time being.

Common questions about interest rates

How do interest rates work?

Financial institutions charge borrowers interest on loans and pay interest to savers and depositors. These rates reflect the base lending rates that central banks set as economic conditions change. Maintaining price stability is normally part of a central bank’s mandate; in most cases, this involves aiming for core inflation of around 2%. When inflation drops below target, a central bank may lower base lending rates to encourage borrowing and support economic activity. Conversely, inflation substantially above 2% will normally prompt an increase in base lending rates to help bring price growth down.

Why do interest rates affect currencies?

A country’s currency generally benefits from higher interest rates, as the country becomes a more attractive destination for global investors’ funds.

Why does Gold respond to interest rate changes?

Gold prices generally face pressure when interest rates rise. Higher rates increase the opportunity cost of holding Gold rather than buying an interest-bearing asset or keeping money in a bank. High interest rates also tend to strengthen the US Dollar (USD). As Gold is priced in Dollars, a stronger US currency has the effect of reducing its price.

What does the Fed Funds rate represent?

US banks lend to one another overnight at the Fed funds rate. Set by the Federal Reserve at its FOMC meetings, this is the headline rate commonly cited in market reports. The Fed specifies a range, such as 4.75%-5.00%, with the upper end (5.00% in this example) used as the quoted figure. The CME FedWatch tool tracks market expectations for the future Fed funds rate. Those expectations influence the behaviour of many financial markets as they anticipate upcoming Federal Reserve monetary policy decisions.