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The Canadian dollar has been losing ground over the past two months, but don’t pin the blame on softer commodity prices, shifting Bank of Canada monetary policies or general risk aversion among global investors.

Instead, the loonie’s retreat appears largely driven by a widespread belief the U.S. Federal Reserve will tighten its monetary policy sooner than was expected earlier this year, because of a recovering economy and rising inflation expectations.

“We now envisage a higher floor for the U.S. dollar against other currencies,” Bipan Rai, an economist at CIBC World Markets, said in a note this week.

The Canadian dollar fell to 79.3 US cents on Thursday – touching its lowest level since April, and down a total of 3.8 US cents from its recent high of 83.1 US cents on June 2.

To be sure, the loonie is no slouch. Earlier this week, it was still the top-performing currency against the U.S. dollar this year among the G10 industrialized countries.

It is also well above its recent low during the depths of COVID-19 lockdowns and the global economic downturn in March, 2020, when it fell below 70 US cents.

But the loonie has clearly lost its momentum as central banks worldwide consider withdrawing stimulus.

The Fed and the Bank of Canada slashed their interest rates during the pandemic and introduced extraordinary measures such as purchases of bonds and other assets (a policy known as quantitative easing). These measures are looking increasingly at odds with rising employment and inflation, along with declining cases of COVID-19 in Canada and the United States.

On its way up, the Canadian dollar was driven by the market’s expectations the Bank of Canada would tighten its monetary policy before the Fed, a view underscored by the Canadian central bank’s optimistic outlook in April and its subsequent tapering of asset purchases.

But this view is changing, with markets now focused on the prospect of more rapid withdrawal of U.S. stimulus.

In June, Fed officials – led by chair Jerome Powell – began talking about raising interest rates earlier than expected. Some analysts forecast hikes will start as soon as next year. Fed officials are also considering tapering its asset purchases.

This is no idle chatter: U.S. inflation clocked in at 5.4 per cent in June. That’s the highest year-over-year reading since August, 2008, and suggests some sort of Fed action is needed. Canadian inflation, though also rising, is more muted, at 3.6 per cent in May.

“The U.S. recovery continues to forge ahead (stumbling a little, on supply problems), while recoveries elsewhere – I’m looking at Europe and Asia – are now facing a risk of being cut short by the Delta variant,” Jennifer Lee, senior economist at BMO Capital Markets, said in an e-mail.

“So what looks good in the face of this? The U.S. dollar,” Ms. Lee added.

Where the loonie goes from here will depend largely on how the Fed reacts to the pace of U.S. economic growth.

Katherine Judge and Avery Shenfeld, economists at CIBC World Markets, believe the market’s recalibration of U.S. rate hikes will weigh on the Canadian dollar for the rest of 2021. They expect the dollar will end the year slightly below 79 US cents.

Next year could bring more of the same, as Canadian economic growth and inflation lag U.S. numbers.

“As a result, look for the Canadian dollar to continue to lose its luster through 2022 on more aggressive policy action from the Fed,” the economists said in a note.

However, there is a bullish case. Shaun Osborne, chief forex strategist at Bank of Nova Scotia, expects blockbuster Canadian economic data will support the case for Bank of Canada rate hikes as lockdowns are eased and lifted.

Mr. Osborne expects the central bank will remain at the forefront of global peers in withdrawing stimulus, putting the loonie on a rebound above 81 US cents as the greenback weakens over the rest of the summer.

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