The Canadian dollar suddenly fell about half a cent, slipping below 81 cents (U.S.) against the U.S. dollar, after the release of the monetary policy statement from the Federal Reserve on Wednesday suggested that U.S. interest rates are heading higher.
As the Canadian dollar fell, the U.S. dollar index - which measures the value of the U.S. dollar against a basket of foreign currencies - spiked 0.8 per cent.
The Fed left its benchmark rate at a range between 1 per cent and 1.25 per cent, as economists had been expecting. However, the central bank maintained an upbeat view on the economy and affirmed its intention to raise rates four times by the end of next year, including one hike by the end of this year.
That is considerably more hawkish than the collective view of financial markets, which are pricing in just one rate hike over this period, due to low inflation.
"The Fed maintained a positive view on the economy as evidenced by upgrades to its growth forecasts, and it left the door open for higher rates ahead," Krishen Rangasamy and Paul-André Pinsonnault, economists at National Bank Financial, said in a note.
In its accompanying economic projections, the Fed raised its economic growth forecast to 2.4 per cent this year, up 0.2 percentage points. It also believes growth will be 2 per cent to 2.3 per cent in 2018, up from a previous forecast for growth of 1.8 per cent to 2.2 per cent.
The outlook comes as U.S. inflation remains stubbornly low, despite a low unemployment rate and what the Fed calls "solid" job gains.
"We had suspected that the recent softness of core inflation could persuade officials to hold off on the next rate hike until next year but, given these latest projections and the broadly unchanged language on inflation in today's policy statement, we now expect the Fed to push on and raise rates again in December," Andrew Hunter, an economist at Capital Economics, said in a note.
The Canadian dollar has been exceptionally strong against the U.S. dollar since the start of the summer, when the Bank of Canada surprised many observers with a bullish economic outlook that has translated into two rate hikes totalling a half a percentage point. The Bank of Canada's rate now sits at 1 per cent.
The rate increases spurred the loonie to rise above 82 cents against the U.S. dollar recent, a 10-per-cent improvement that marks the biggest quarterly upward move in over a decade, according to National Bank.
Apart from currency moves, yields on short-term and longer-term U.S. Treasuries also rose Wednesday following the Fed's statement.
Bank of Nova Scotia economists believe that with the Fed sounding surprisingly hawkish, the Bank of Canada may have fewer reasons to fear additional gains by the Canadian dollar if the central bank continues to raise Canadian rates.
At the same time, the U.S. dollar has been weak against a basket of currencies, given the clouded outlook over the Fed's monetary policy due to the low rate of inflation. The Fed expects that inflation will remain below its 2 per cent target over the next 12 months, but should rise to 2 per cent in the medium term.
"Currency risks have therefore abated somewhat and with Fed rate hike guidance remaining unchanged in 2017-18, prospects for further Bank of Canada policy tightening just got an added boost in keeping with our views for another hike this year and at least 2 more next year with the risk perhaps skewed toward more rather than fewer," said Scotiabank's Derek Holt in a note.