Recent factors affecting the Canada-US exchange rate

The Canadian dollar has declined against the US dollar since October 2024, mostly due to rising uncertainty around trade policies. A widening differential in policy interest rates between the two countries has also played a modest role.

In recent months, the rising uncertainty and the widening interest rate differential have both played a role in the depreciation of the Canadian dollar. The relative contribution of each component can be better understood by examining how they influence the exchange rate.1

To what degree do interest rate differentials affect the exchange rate? 

The widening differential between interest rates in Canada and the United States is one reason for the recent depreciation in the Canadian dollar. But how large of a role has it played?

The following example helps gauge the impact. Consider an investment in one-year treasury bills in Canada and in the United States. Both offer guaranteed returns after one year. If the return on the Canadian treasury bills decreases to 1 percentage point below the return offered by US Treasury bills, then investing in the United States becomes relatively more attractive. In this case, investor demand for Canadian dollars declines, and the market value of the Canadian dollar temporarily depreciates below its long-term value by about 1%. Because of this depreciation, investors now have reason to expect that the Canadian dollar will appreciate by 1% over the next year, which offsets the 1-percentage-point difference in returns between the bills.2

The above example roughly matches what has happened since October 2024. The widening differential between Canadian and US interest rates of about 1 percentage point has contributed to a roughly 1% depreciation in the Canadian dollar. This leaves most of the remaining observed depreciation since October 2024 unaccounted for.

Exchange rate risk can also affect the value of the Canadian dollar

Exchange rate risk also plays an important role in investors’ decisions and therefore affects the exchange rates between currencies.

Continuing with the above example, when foreign investors buy Canadian treasury bills, they bear the risk of unexpected changes in the value of the Canadian dollar while the asset is held.

During periods of heightened uncertainty, investors typically demand a premium to compensate them for the additional exchange rate risk or to cover the cost of purchasing insurance in the form of options or futures contracts. This premium is known as the foreign exchange rate risk premium, and an increase in its value is associated with a depreciation of the exchange rate.3

The risks around the Canadian dollar and other currencies have been amplified since the US election, partly due to the uncertainty caused by the threat of US tariffs (Chart 29). Activity in markets for options and futures contracts reveals the increased concerns that the Canadian dollar could depreciate further (Chart 30). For example:

• Asset managers have increased their short positions in currency futures, which protect against devaluation of the Canadian dollar.
• Prices have risen for other derivatives contracts, including options contracts, which are used to insure against a depreciation of the Canadian dollar.

These increased concerns have added to the foreign exchange rate risk premium and have contributed to the depreciation of the Canadian dollar.

How does each factor contribute to the change in the exchange rate?

The relative contributions from the interest rate differential and the foreign exchange rate risk premium on the recent depreciation in the Canadian dollar can be estimated.4 Bank of Canada staff find that:

• The widening interest rate differential is estimated to account for a relatively modest share of the overall depreciation.
• Most of the depreciation is explained by the foreign exchange rate risk premium (Chart 31).

Bank staff also find that most of the depreciation in the currencies of other advanced economies relative to the US dollar is explained by the changes in their foreign exchange rate risk premium. Indeed, these depreciations all share common timing and patterns (Chart 32).

The foreign exchange rate risk premium increases when uncertainty is heightened. While there are many reasons why uncertainty has risen in recent months, much is due to US President Donald Trump’s threat of import tariffs. In practice, it is very difficult to distinguish between exchange rate depreciations that reflect pure uncertainty effects and changes in market expectations about the long-run value of the exchange rate.

Endnotes