Canadian Dollar set for second weekly decline despite pullback in US Dollar

USD/CAD trades little changed on Friday as the US Dollar (USD) pulls back slightly after a strong rally this week. The pause in the Greenback and Treasury yields has offered little relief to the Canadian Dollar (CAD), leaving it on track for a second consecutive weekly decline. At the time of writing, the pair trades around 1.4141, near levels last seen in mid-July.

The Canadian Dollar is struggling to benefit from the softer US Dollar as the Federal Reserve (Fed) and the Bank of Canada (BoC) follow different policy paths. The Fed raised interest rates by 25 basis points (bps) last week to 3.75%-4.00% and signalled that another increase may be needed this year. The BoC, by contrast, has kept its policy rate at 2.25% and adopted a more cautious stance, noting little evidence that higher energy prices have spread into broader inflation.

The policy gap and prospects of additional Federal Reserve hikes have widened the front-end yield differential in favour of the US Dollar. As of writing, the US Dollar Index (DXY), which tracks the Greenback’s value against a basket of six major currencies, trades around 101 after reaching 101.40 on Thursday, its highest level in nearly two months.

The two-year US Treasury yield trades around 4.87%, slightly below Wednesday’s peak of 4.94%, its highest level since 2004. By comparison, Canada’s two-year government bond yield stands near 3.35%, leaving a yield gap of almost 150 basis points in favour of the US Dollar (USD).

The Loonie’s weakness comes despite support from elevated Oil prices, one of Canada’s main exports. Traders are instead focusing on the interest rate differential, the stronger US growth outlook, higher US yields and the risk that new US tariffs could weigh on Canadian activity. Bank of Canada Governor Tiff Macklem recently warned that tariffs could push Canadian fourth-quarter growth below 1%.

Next week, traders will focus on the US Personal Consumption Expenditures (PCE) inflation report, the ISM Manufacturing Purchasing Managers’ Index (PMI), the Nonfarm Payrolls (NFP) report and Canada’s July Gross Domestic Product (GDP) data.