Canadian Dollar Up Despite Canadian Interest Rate Cut

As reported on Monday analysts expected the Bank of Canada to cut interest rates on September 3rd. That's precisely what happened, as the Bank of Canada reduced the overnight rate 25 points to 2.75. Currency markets seem to suggest that some investors were caught off guard by the move.

In Part 7 of the series "A Beginner's Guide to Exchange Rates and the Foreign Exchange Market" we saw that a reduction in the interest rate of a country will cause a reduction in the value of that currency relative to other countries. In "How Markets Use Information To Set Prices" we saw how prices, such as exchange rates, are influenced by the beliefs held by market participants. The Canadian dollar had been declining in value relative to the U.S. dollar a few days before the annoucement. However, after the annoucement of the 25 point cut came, the Canadian dollar rose 0.61 cents relative to the U.S. dollar, according to Canada.Com.

Generally a currency rises during an unexpected rate hike, and falls relative to an unexpected rate decline. Since the Canadian dollar rose, it seems pretty safe to assume that the market was expecting a larger cut, so the annoucement of a small 25 point cut acted like an unexpected rate hike (since the rate ended up being higher than many felt it would be), and the Canadian dollar appreciated in value.

Important Links

• To learn more about how beliefs about future changes cause prices such as the interest rate to change today see "How Markets Use Information To Set Prices".

• To learn more about how central bank reactions to inflation and deflation influence interest rates see "What is deflation".

• To learn about the link between exchange rates and interest rates see my "Guide to Exchange Rates".

• You may also want to see "The Canadian Exchange Rate" which details the performance of the Canadian Dollar during the first half of 2003.