April 20, 2010 / 2:23 PM / in 8 years

BoC's rate hike signal pulls Canada dollar above parity

TORONTO (Reuters) - Canada’s dollar punched through parity with the U.S. currency on Tuesday after the Bank of Canada abandoned its conditional commitment to keep rates steady until the end of June.

The central bank became the first in the Group of Seven countries to hint it may raise interest rates, possibly as early as June 1, as the economy heals after recession. For now, the bank kept its key rate at its current ultra-low 0.25 percent level.

Currencies usually strengthen as interest rates rise as higher rates attract capital flows.

The bank has kept the overnight rate at the current historic low since April 2009. Until Tuesday it had pledged to hold it at that level until the end of June unless inflation strays off the bank’s desired path.

The currency rallied to a high of C$0.9970 to the U.S. dollar, or $1.0030, as the market interpreted the dropped commitment as a signal the central bank is now more likely to hike rates in June than in July, as most in the market had previously forecast.

“They have definitely left their options wide open and the market is responding appropriately,” said Doug Porter, deputy chief economist at BMO Capital Markets.

The Canadian dollar finished at C$0.9988 to the U.S. dollar, or $1.0012, its highest close since late May 2008. It also ended higher for the first time in four sessions, and was up from Monday’s close of C$1.0148 to the U.S. dollar, or 98.54 U.S. cents.

The Canadian currency was last at one-for-one footing with the greenback on April 15.

“I think Canada wins on either defensive or offensive market plays over the next year,” said Derek Holt, vice president, economics, at Scotia Capital.

“If you’re worried about political risk and sovereign default risks globally then Canada offers relative insulation against those downsides so you’d want to overweight the Canadian dollar in that scenario,” he said.

“At the same time if you think that the consensus of economists and market participants is underestimating growth and the upsides to commodities, then you would want more offensive weight in Canada.”

Yields on overnight index swaps, which trade based on expectations for the central bank’s key policy rate, edged higher after the bank’s statement was released and now suggest there is about a 93 percent chance of a June rate hike.

As well, a Reuters poll conducted on Tuesday following the statement showed most of the country’s primary securities dealers now say the Bank of Canada will raise interest rates in June instead of July.

Market watchers say focus now turns to the central bank’s Monetary Policy Report on Thursday and the release of March inflation data on Friday.

BOND PRICES DROP

Canadian bond prices fell across the curve after the rate announcement on expectations of a higher rate environment.

Bond prices typically fall when rates are on the rise as their fixed payments look less attractive in comparison with the rising yields on other short-term investments.

“We’ve seen an across-the-board selloff with the likelihood the bank will be acting earlier and more aggressively than expected,” said BMO’s Porter.

The move lower also mimicked U.S. Treasuries, where prices retreated on Tuesday as strong earnings stalled a safe-haven rally in U.S. government debt.

The two-year government bond was down 31 Canadian cents at C$99.09 to yield 2.003 percent, while the 10-year bond fell 35 Canadian cents to C$100.37 to yield 3.702 percent.

Canadian government bonds mostly underperformed U.S. issues, with the two-year yield 99.5 basis points above its U.S. counterpart, compared with around 85 basis points the previous session.

Additional reporting by Claire Sibonney; editing by Peter Galloway

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