Will a rate hike drive the Canadian dollar higher?

The Bank of Canada's interest rate announcement on Tuesday could mark a watershed moment: Odds are the central bank will raise rates for the first time in nearly three years. It's something foreign-exchange traders have been anticipating for months - and something that, we've been told, has been a key driver in the Canadian dollar's rally over the past year.

Some observers fear that the advent of Canadian rate hikes, especially with central banks in much of the industrial world still on indefinite hold, could propel the currency even higher and put a further strain on export-oriented businesses. But would rising Canadian rates really be the rocket fuel for the currency that many commentators would have you believe?

The answer may lie in the currency of another export-oriented, resource-heavy economy that has already experienced the impact of central bank rate hikes in the past year: Australia. And, the answer would appear to be "no."

THE AUSSIE EXPERIENCE

The Reserve Bank of Australia started raising its benchmark interest rate last October, and had increased it by 1.5 percentage points by early May - when it signalled that it was finished with its rate hikes. The Australian dollar did, indeed, rise during the rate-hiking cycle, actually beginning to rally in advance of the first increase.

But then a funny thing happened: The rally stalled, then reversed, even as the RBA continued to raise rates. If the rate hikes were ever a driver for the Aussie dollar, the effect fizzled remarkably quickly.

In fact, the Australian dollar's fate has been aligned much more closely with two other factors: risk and commodity prices.

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THE VIX AND THE CRB

The accompanying charts show the Aussie dollar over the past year, and compares it to both an inverted graph of the VIX index of equity market volatility (a simple proxy for financial market risk) and the Reuters/Jefferies CRB index of commodity prices. We've also added the Canadian dollar, for comparison.

The results show that during the entire rate-hiking cycle, the Aussie dollar routinely fell when market risk surged, and rallied when it ebbed. The Canadian dollar's path has been strikingly similar - even though the Bank of Canada was, by contrast, steadfastly on hold.

Similarly, both currencies tracked the strength of commodity prices closely, though not quite as closely as the risk indicator.

What's this telling us? That for cyclical, resource-based currencies, the threats of rising risk and wavering export demand have been much bigger issues than interest rate differentials.

If the Aussie experience is any guide, expect anything the Bank of Canada does to take a back seat to the ebb and flow of global financial and economic concerns for the next few months.