Canadian Dollar falls to two-month low as higher US yields outweigh Oil support

• USD/CAD extends its rally as Fed-BoC monetary policy divergence favours the US Dollar.
• Canadian Retail Sales fall in July, adding to pressure on the Canadian Dollar.
• Resilient US data and hawkish Fed comments keep another interest-rate hike on the table.

USD/CAD extends its advance on Thursday, climbing to its highest level since mid-July. The pair has posted only one daily decline over the past 12 trading days, reflecting the diverging monetary policy outlooks of the Federal Reserve (Fed) and the Bank of Canada (BoC). At the time of writing, USD/CAD trades around 1.4113, up nearly 2% so far this month.

Canadian Dollar struggles as US-Canada yield gap widens

Canadian Retail Sales data offered little support to the Canadian Dollar (CAD). Headline sales fell 0.7% MoM in July, slightly better than the 0.8% drop expected, while sales excluding automobiles also declined 0.7%

The recent USD/CAD rally is largely driven by the widening gap between short-term US and Canadian bond yields. The two-year US Treasury yield trades around 4.89%, slightly below Wednesday’s peak of 4.94%, its highest level since 2004. By comparison, Canada’s two-year government bond yield stands near 3.40%, leaving a gap of almost 150 basis points in favour of the US Dollar (USD).

US Treasury yields are rising across the curve as traders see a growing chance that the Fed will raise interest rates again later this year. The central bank delivered a 25-basis-point (bps) increase last week, lifting the federal funds rate to 3.75%-4.00%.

The hawkish shift has fuelled broad demand for the Greenback. The US Dollar Index (DXY), which tracks the currency against a basket of six major peers, trades around 101.37, its highest level since July 29.

Recent US economic data has strengthened the case for additional tightening. Initial Jobless Claims rose slightly to 197K from 196K but came in below the 201K forecast, pointing to limited layoffs. The S&P Global Composite Purchasing Managers’ Index (PMI) also climbed to a five-year high of 58.4 in September from 56.0 in August.

Fed officials have kept another rate hike on the table as inflation stays above the central bank’s 2% target. New York Fed President John Williams said, “We need to get inflation back to target in a timely manner,” adding that it is “reasonable to see another rate hike by the end of the year.” The CME FedWatch Tool places the probability of an October rate increase at around 65%, up from 55% a week ago.

Steady BoC policy outweighs support from higher Oil prices

In contrast, the BoC kept its policy rate unchanged at 2.25% for a seventh consecutive meeting earlier this month. The central bank noted that there was little evidence of higher energy prices spreading into broader inflation, with inflation excluding gasoline at 2.2% and core measures close to 2% in July.

The BoC acknowledged that upside inflation risks have increased but also warned that new US tariffs cloud the growth outlook. Interest-rate expectations are also outweighing the support that the commodity-linked Canadian Dollar would typically receive from higher Oil prices. West Texas Intermediate (WTI) Oil trades around $95, up nearly 11% so far this month.