March 18, 2008 / 9:24 PM / in 9 years

Loonie firms after inflation data, Fed cut

<p>A Canadian one dollar coin, also know as a loonie, is shown in Montreal, April 28, 2006.Shaun Best</p>

TORONTO (Reuters) - The Canadian dollar strengthened against the greenback on Tuesday, after the U.S. Federal Reserve cut interest rates less than expected and a domestic inflation report was seen leaving the Bank of Canada room to cut its rates further.

Domestic bond prices ended lower across the curve after the Fed's 75 basis point rate cut, as investors softened expectations of how aggressive the U.S. central bank's easing campaign would be.

The Canadian dollar closed at US$1.0048, valuing a U.S. dollar at 99.52 Canadian cents, up from US$1.0007, valuing a U.S. dollar at 99.93 Canadian cents, at Monday's close.

The currency hit its peak at the beginning of the session, touching US$1.0109, making a greenback worth 98.92 Canadian cents, after the domestic inflation report.

The data showed Canada's overall annual inflation rate eased in February, but core inflation, which excludes volatile items like gasoline, and guides monetary policy, rose for the first time in eight months, to 1.5 percent from 1.4 percent in January.

"It does remind you that, at some point, the pass-through of the rise of the Canadian dollar, which has been over for a while, will begin to fade away and maybe this is the beginning of that," said Don Drummond, chief economist at Toronto-Dominion Bank.

Inflation had been easing as the effects of the strong Canadian dollar, which rose 17.5 percent against the greenback last year, made imported goods cheaper.

Even with the rise, core inflation was well within the central bank's range of 1 to 3 percent and left the door open to more rates cuts, if needed, to deal with the effects of the economic slowdown south of the border.

A Reuters poll taken on Tuesday afternoon showed the majority of Canada's primary securities dealer expect the Bank of Canada to cut its key lending rate in April by 50 basis points to 3.00 percent.

Strong oil and gold prices, along with a more upbeat mood in equity markets helped the commodity-linked Canadian dollar hang on to some gains leading into the Fed's rate decision.

The Fed cut by its key lending rate by a hefty, but still smaller than expected, 75 basis points, to 2.25 percent.

That opened up an interest rate differential of 1.25 percent in favor of the Canadian dollar, but the currency failed to make strong inroads against the greenback.

"The Fed cut less than expected and that resulted in some reassessment of how aggressive the easing campaign will be," said Matthew Strauss, senior currency strategist at RBC Capital Markets.

"There's little doubt in our minds that they will continue to cut, but to do it in steps of maybe 50 or 75 basis points rather than 75 or 100 basis points."

While the Canadian dollar traded sideways against the U.S. dollar for the rest of the session, it made sharp gains on the euro and the pound sterling after the Fed move.

BONDS FALL

Canadian bond prices tumbled along with the larger U.S. market after the Fed's smaller than expected rate cut.

"I think that what the Fed is telling us now is that the period of bringing rates down is not yet over, but we are beginning to see the end of it," said Carlos Leitao, chief economist at Laurentian Bank of Canada.

Some in the market were calling for a cut as big as 125 basis points in order to kick-start the sputtering U.S. economy, and may now be paring back their forecasts.

The two-year bond fell 29 Canadian cents to C$102.93 to yield 2.472 percent. The 10-year bond dropped 63 Canadian cents to C$104.05 to yield 3.480 percent.

The yield spread between the two- and 10-year bonds was 100.8 basis points, down from 109.6 points at the previous close.

The 30-year bond declined 27 Canadian cents to C$117.33 to yield 3.989 percent. In the United States, the 30-year treasury yielded 4.342 percent.

The three-month when-issued T-bill yielded 2.04 percent, down from 2.10 percent at the previous close.

Editing by Rob Wilson

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