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Canadian dollar surges higher after surprise rate tightening

The Canadian dollar surged to its highest level in more than two years against its US counterpart on Wednesday, after the country’s central bank surprised markets by raising interest rates to 1 per cent in response to a stronger economy.

The Canadian dollar, commonly known as the “loonie”, appreciated more than 2c to $1.2119, before easing to $1.2213 in late London trading, a gain of 1.2 per cent on the day.

Canada has been in the vanguard of G10 central banks other than the Federal Reserve shifting policy away from monetary stimulus. Its decision brings into even sharper focus Thursday’s European Central Bank meeting, with traders already keenly awaiting any signs of tapering.

Traders had been expecting the Bank of Canada to keep overnight rates at 0.75 per cent. The market was primed for a likely rate rise in October when the BoC next has a quarterly monetary policy report at its disposal.

But the 25 basis points tightening on the grounds of stronger than expected economic data had investors piling into the loonie, pushing its rise against the US dollar in the past four months to more than 12 per cent and to a level last seen in June 2015.

Stephen Gallo of Bank of Montreal said the BoC move was justified. “Why wait? They’ve got the momentum, the economy is above potential and there is more absorption of spare capacity.

“This is a reminder that central banks have to pick their opportunities very carefully. You can never be sure what conditions will look like down the road.”

In its statement announcing the rate rise, the BoC noted how geopolitical risks and international trade tensions had weakened the US dollar, resulting in some of the loonie’s recent appreciation.

That, said Niall Coffey at Avoca Global Advisors, showed how “Canadian officials now appear more sensitive to their foreign exchange rate policy due to the Trump administration’s frequent trade protectionist rhetoric” and the upcoming renegotiation of the Nafta agreement.

Mr Coffey predicted further upside for the loonie, expecting it to reach C$1.15 before the end of the year.

But, according to Viraj Patel at ING, the second-round effects of further loonie appreciation will be disinflationary and cause the BoC to stay their hand on further rate rises, even though the market is pricing in two more rate increases next year.

“We will start to see the market pricing out some of its optimism,” said Mr Patel.

The message for other central banks, he added, was that “if you’re going to hike you’re going to get a significant [currency] rally in a market looking for any excuse for market drivers”.

Policymakers are sensitive to an overheating Canadian housing market, but the BoC said the housing market appeared to be cooling in some markets as a result of tax and housing finance policy changes.

Although inflation remained below target, “it has evolved largely as expected in July”, the BoC said.

The market was taken by surprise in June when BoC governor Stephen Poloz and his deputy pointedly alerted investors to the prospect of its first rate rise since 2010, which it duly delivered the following month.