The Canadian dollar broke through the 79-cent (U.S.) mark on Tuesday for the first time since last July, capping off a three-month rally that ranks as among the strongest on record.
The currency has snapped back from its diminished state in the winter with a 11-cent upside move, which has corresponded with a revival of sentiment in global markets in general, and commodity markets in particular.
Meanwhile, what was a substantial gap between Canadian and U.S. economic prospects has practically vanished.
But the more the loonie advances, the more it threatens the transition from energy production to non-energy exports. Bank of Canada Governor Stephen Poloz alluded to the pressure of a rising currency in testimony to the House of Commons finance committee on Tuesday.
Economists have suggested that the central bank is trying to discourage excessive currency strength.
"It's without question that the Bank is getting uncomfortable with the dramatic move we've seen in the currency," said Douglas Porter, chief economist at Bank of Montreal. "It does have the potential to fundamentally change their upbeat view on non-resource exports."
"And let's face it, that is the main reason to be optimistic on the Canadian economy," Mr. Porter said.
In that sense, the currency's rally has its own built-in limitations. Above a certain price, the dollar ceases to be a net stimulant for the domestic economy. And that price is not far off, Mr. Porter said.
While a recent upswing in oil prices after the global energy crash has been the decisive contributor to loonie strength, there are several other forces that have acted in support.
A couple of months ago, consensus forecasts for the U.S. economy pegged GDP growth at about 2.5 per cent this year. The Canadian economy was not expected to realize growth much higher than 1 per cent. Those two figures are quickly converging at slightly less than 2 per cent.
Weak economic readings have led to reduced expectations for rate hikes by the U.S. Federal Reserve this year. That has sapped some of the strength from the U.S. dollar that resulted from expected monetary tightening.
"Forecasts for first-quarter U.S. growth have now dropped to zero, compounding Fed Chair Janet Yellen's desire for a cautious approach to raising rates," Jasper Lawler, an analyst with CMC Markets, said in a note.
On Tuesday, Mr. Poloz went so far as to attribute "most of the increase" in the loonie recently to "shifts in expectations about monetary policy in both the United States and Canada."
Canada's improved outlook has also seen currency traders retreat from a position of extreme bearishness.
At one point this winter, the net short position against the loonie on the Chicago Mercantile Exchange amounted to more than 50,000 contracts, where each contract is $100,000. That trade has quickly unwound, recently becoming a small net long position for just the second time in the last year-and-a-half, Mr. Porter said.
The Canadian dollar has also benefited from technical support, Bank of Nova Scotia currency strategists Shaun Osborne and Eric Theoret said in a report.
"The most recent gains in the [Canadian dollar] appear to reflect momentum taking over from where fundamentals have brought us so far," the report said. "We think the bear trend in the [U.S.] dollar is well-entrenched in the market at this point."
But for all the sources of loonie strength right now, an extension of the rally is going to require the help of crude oil and other commodities, the analysts said.
"Among the major currencies, the [loonie] currently has the strongest, positive correlation with crude prices and remains closely tied to the broader trend in commodities."
Already, the Canadian currency has appreciated by 16 per cent against the U.S. dollar over the past three months, which is "exceptionally rare" in its speed and magnitude, Mr. Porter said.
In its quarterly monetary policy report, which was released last week, the Bank of Canada mentioned the stronger dollar as a headwind for non-energy exports. "We see this as gentle jawboning – an attempt to prevent the Canadian dollar from strengthening even as they upgrade growth," Merrill Lynch said in a report.
The stronger loonie also acts to mute the benefits of the recent jump in oil prices for Western Canadian producers. Canada's oil exporters are helped by a weaker loonie because they get paid in U.S. dollars while expenses are tied to the domestic currency. That provided a sizeable cushion as global crude prices sank under $30 a barrel earlier this year, even as profits dried up and producers cut billions of dollars in planned capital spending.
Now the reverse is happening. Gains in the loonie are tempering the benefits from higher U.S. crude prices. Barclays PLC analysts, taking into account recent moves in energy prices and currencies, said they expect cash flow at mid-sized exploration and production companies in 2016 to slump by an average 6 per cent a share from previous estimates, led by steep declines at Trilogy Energy Corp., Paramount Resources Ltd. and Peyto Exploration and Development Corp. That's despite the bank's revised outlook for West Texas intermediate oil to average $42 a barrel in 2016, rising to $50 next year. It previously forecast WTI at $37 and $45 a barrel, respectively.
Should the loonie continue to advance past the 80-cent mark, Mr. Poloz may become more vocal to tame its rise, Mr. Porter said.