TORONTO (Reuters) - The Canadian dollar shot back above par with the U.S. dollar on Tuesday, supported by firmer commodity prices, expectations of an increasingly favorable U.S.-Canada interest rate spread, and calmer equities markets.
Canadian bond prices fell as investors positioned themselves ahead of Wednesday's U.S. Federal Open Market Committee interest rate decision.
The Canadian currency closed the North American session at US$1.0005, valuing a U.S. dollar at 99.95 Canadian cents, up from C$1.0044 to the U.S. dollar, or 99.56 U.S. cents, at Monday's close.
Rising oil prices in the overnight session helped float the commodity-influenced Canadian unit above par.
That triggered some technical buying, which pushed it up to US$1.0055, valuing a U.S. dollar at 99.45 Canadian cents, the Canadian currency's highest level since Jan 4.
The Canadian dollar has most likely settled into a holding pattern ahead of the Fed interest rate decision on Wednesday, said Matthew Strauss, senior currency strategist at RBC Capital Markets.
The Fed is widely expected to cut its key lending rate by half-a-percentage point, bringing the fed funds rate to 3 percent as it tries to bolster the U.S. economy.
The Bank of Canada's key lending rate is at 4 percent.
Most U.S. economic data lately has pointed to a serious downturn in the U.S. economy, prompting some market analysts to declare that the U.S. is in a recession.
Further cuts to the fed funds rate would stimulate growth by encouraging domestic spending, but it would make the greenback less attractive to investors.
The Fed has already cut interest rates by 125 basis points since September, including a 75-basis-point emergency cut last week.
Since that aggressive move, the Canadian dollar has gained 3.3 percent against the greenback.
The growing interest rate spread is the primary cause of the stronger Canadian dollar, Strauss said.
He also noted that the Fed's actions will benefit the Canadian economy indirectly and that is also boosting the bid for the Canadian dollar.
"If the U.S. economy is not going to fall into recession, or if its only going to be a mild, brief recession, that would help the Canadian economy quite significantly, from the perspective that, given the strong domestic momentum, the (Canadian) economy could continue growing closer to 2 percent rather than 1 percent."
Exports make up around 40 percent of the Canadian economy and the U.S. absorbs around 75 percent of Canadian exports.
The Fed expectations also acted to inject some stability to the recently volatile stock markets, which are being viewed as a barometer for the health of the global economy.
Canadian bond prices slid as investors positioned themselves ahead of Wednesday's Fed announcement.
Another factor in the declining prices was the calm in the stock markets, which took away the flight to quality bid for government debt, said Sheldon Dong, fixed income analyst with TD Waterhouse Private Investment.
The latest piece of domestic data showed manufacturers in Canada reported the bleakest outlook on production since 2002 given the lofty Canadian dollar, high oil prices and a slowdown in the U.S. economy.
The two-year bond fell 17 Canadian cents to C$101.69 to yield 3.292 percent. The 10-year bond slid 52 Canadian cents at C$100.71 to yield 3.907 percent.
The yield spread between the two-year and 10-year bond was 61.5 basis points, down from 63.7 points at the previous close.
The 30-year bond slipped 68 Canadian cents to C$113.80 to yield 4.179 percent. In the United States, the 30-year Treasury yielded 4.360 percent.
The three-month when-issued T-bill yielded 3.40 percent, down from 3.41 percent at the previous close.
Editing by Peter Galloway