Will loonie’s big rally be sustainable in long run?

The Canadian dollar’s surge to US 80 cents has come quickly, as the currency is up nearly 10 per cent since early May. But if the strength is rooted in expectations about central bank policy and higher interest rates in particular, is the loonie’s rally sustainable?

Providing some much-needed relief to Canadian importers, cross-border shoppers, and of course, investors, the Canadian dollar has been the world’s bestperforming major currency in the past two-and-a-half months. Talk of a strengthening domestic economy was supported by the Bank of Canada’s first rate hike in seven years on July 12. The currency was trading at US 79.97 cents Tuesday at midday.

So with the next key economic release in Canada being Friday’s GDP report for May, for now the focus shifts to the U.S., where the Federal Open Market Committee begins its two-day policy meeting.

The Fed’s statement is expected to include a few tweaks in its language, likely acknowledging softer inflation trends, but nothing that should change the bank’s policy amid tightening labour markets.

“However, investors appear to be sharing our opinion that the political landscape in Washington may well preclude any effective advancement of the President’s economic agenda for the foreseeable future, leaving the U.S. dollar prone to further weakness as the U.S. economy’s growth — and the U.S. dollar’s yield — advantage deteriorate relative to other major economies,” said Shaun Osborne, chief FX strategist at Scotiabank.

The market also appears to be more concerned that the Fed won’t be able to make progress toward achieving its inflation goal. Osborne pointed to poor results from last week’s 10-year TIPS auction, which he believes implies doubt about the Fed’s base case of one more rate hike in 2017.

“The outlook for relative central bank policy remains a key driver for the Canadian dollar,” his currency strategy colleague Eric Theoret said in a report. “We remain bullish CAD.”

Swap prices in the interest rate market now imply nearly 25 basis points of tightening for the BoC’s October meeting, and Friday ’s Commodity Futures Trading Commission report lends further support to the loonie. It showed that speculators hold a net long position in the Canadian dollar for the first time since mid-March, after eight consecutive weeks of sentiment improvement. That’s been driven by short covering, and more recently, fresh long positions.

A clear sign that the loonie is responding to BoC rate hike expectations (and a more dovish Fed) came on Friday, when the currency rallied 0.4 per cent despite a 2.3 per cent decline in oil prices. But that hasn’t convinced David Rosenberg, chief strategist and economist at Gluskin Sheff + Associates, that the Canadian dollar’s big rally will continue.

“While the Fed has good reason to be less strident on its growth and inflation view, the same could be said for the Bank of Canada,” Rosenberg said in his daily report.

He noted that since the loonie’s lows in May, the move higher is equivalent to almost 300 basis points of policy tightening, and the power of the run-up since July 12 has been nearly double that of the actual rate increase.

Rosenberg believes BoC governor Stephen Poloz, who used to be chief executive of Export Development Canada, may begin to downplay the need for more rate hikes in an attempt to curb the loonie’s rally. “…The bank is likely to follow in Yellen’s footsteps and back away a bit from the rate-hiking threat (at least for the next several months,” the strategist wrote.

If that happens, expect the Canadian dollar to cool off. If it doesn’t, and the BoC seems to remain on the rate-hiking path while the Fed stands pat, the loonie has room to run.