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TORONTO (Reuters) - The Canadian dollar rose against the U.S. dollar after the U.S. Federal Reserve cut its key lending rate by half a percentage point, creating an interest rate spread in favor of the Canadian currency not seen since June 2004.
Canadian bond prices were mixed in response to the Fed and the prospect of more rate cuts to come.
The Canadian dollar was at US$1.0068, valuing a U.S. dollar at 99.32 Canadian cents, up from US$1.0005, or 99.95 Canadian cents, at Tuesday's North American session close.
The Canadian dollar rose as high as US$1.0131, valuing a U.S. dollar at 98.71 Canadian cents, shortly after the Fed's announcement.
The Fed has now slashed U.S. interest rates by 225 basis points since September as it grapples with an economic downturn.
In that time, the Bank of Canada has also cut its key lending rate, but less drastically, for a total of 50 basis points.
That puts U.S. interest rates 1 percentage point lower than Canadian interest rates, which should make the Canadian dollar more attractive to investors versus the greenback.
But other factors may keep the Canadian dollar from appreciating much further, said Steve Butler, director of foreign exchange at Scotia Capital.
Comments by Bank of Canada Senior Deputy Governor Paul Jenkins to a House of Commons committee, after the Fed's move, reinforced the view that Canadian interest rates will most likely fall further in the near term.
"It certainly looks like there's going to be more rate cuts in Canada and all the worries about the U.S. economy are going to affect Canada at some point as well," Butler said.
North American stock markets, which had rallied after the Fed cut, lost their gains as credit crunch fears resurfaced, which doesn't bode well for the Canadian dollar, Butler said.
"The optimistic view was for a 50-basis-point cut by the Fed, we got our 50, and then to see the equities fail to sustain their rally, I think it's very disappointing."
The stock markets are being viewed as a barometer of the health of the world economy and the direction of Canadian dollar has been strongly influenced them as of late.
Canada is a major commodities exporter and a global slowdown would likely crimp commodity prices.
Canadian bond prices were mixed, as the short end rallied in anticipation of more Fed cuts to come, but the long end turned negative, possibly on inflation fears.
"I think the market is perhaps beginning to think that at some point inflation might be a problem," said Carlos Leitao, chief economist at Laurentian Bank of Canada.
"You can't keep on pushing rates down like that without generating some inflationary movement."
The two-year bond climbed 21 Canadian cents to C$101.89 to yield 3.176 percent. The 10-year bond rose 22 Canadian cents to C$100.92 to yield 3.881 percent.
The yield spread between the two-year and 10-year bond was 70.5 basis points, up from 61.5 points at the previous close.
The 30-year bond slipped 12 Canadian cents to C$113.63 to yield 4.188 percent. In the United States, the 30-year Treasury yielded 4.375 percent.
The three-month when-issued T-bill yielded 3.39 percent, down from 3.40 percent at the previous close.
Editing by Peter Galloway