Loonie eyes 130-year high if Fed makes big rate cut

TORONTO (Reuters) - The Canadian dollar could reach its highest level against the greenback in nearly 130 years if the Federal Reserve shocks currency markets this week with a bigger than expected rate cut or signals further easing.

After hitting a 47-year high on Monday, the Canadian dollar is now just over a penny away from reaching its highest level since the late 1800s.

The market has fully priced in a 25 basis point cut to the U.S. fed funds rate on Wednesday, a move that would make key U.S. and Canadian interest rates equal for the first time since February 2005, at 4.50 percent.

But if the U.S. central bank signals another rate cut in December, or if it goes against expectations and chops rates by 50 basis points, it could pull the rug out from under an already unsteady U.S. dollar and clear the way for the Canadian currency to shoot higher.

“Certainly a larger than expected cut would lift the loonie and all other currencies against the beleaguered greenback,” said Sal Guatieri, senior economist at BMO Capital Markets.

“As well, if they just cut 25 basis points and the statement hints at more cuts to come that would certainly support the currency as well.”

Since falling to its all-time low versus the U.S. dollar in January 2002, the Canadian dollar has rallied sharply given a slew of factors that include lofty commodity prices, a robust domestic economy and merger-related interest.

Last month, the currency shot through parity with the U.S. dollar for the first time since 1976 and it has not shown any signs of slowing down.

Benjamin Tal, senior economist at CIBC World Markets, said he expects the Fed to hold any rate cut to 25 basis points. He noted it has never really gone against market expectations about its rate moves since 1994, adding it was unlikely to do so now given the fragile U.S. economy.

And while Tal said any talk about further Fed rate cuts may ignite chatter about an ensuing Bank of Canada cut, he does not expect it to weigh on the domestic currency.

“The net result of any situation of a further rate cut by the Fed will be positive for the Canadian dollar,” said Tal. “Not negative, because it means the Fed is doing something in order to prevent a recession and Canada would be a free rider out of it.”

Canada relies heavily on exports to the United States, its biggest trading partner, so any significant slowdown south of the border could squeeze economic growth in Canada.

At 11:30 a.m. Tuesday the domestic currency was at US$1.0478, making the U.S. dollar worth 95.43 Canadian cents. The record high for the currency was reached in July 1864, when the Canadian dollar was at US$2.78.

With a 25 basis point cut priced into the market, it will likely take either a surprise 50 point cut on Wednesday or a clear signal that more easing is in store to trigger further meaty gains for the Canadian dollar.

“If they did go 50 (basis points) markets would get a little more worried that the Fed is seeing, or is more worried about, something that they are not even worried about yet and then you’d get a pretty extreme reaction,” said Craig Wright, chief economist at Royal Bank of Canada.

Expectations for a big rate cut cooled on Tuesday as the Wall St. Journal’s Fed watcher, who is known for reflecting the views of senior central bankers, said a cut is no sure thing and officials were not putting much weight into a 50 basis point cut.

And if the Fed decides to leave rates steady, the Canadian dollar would likely hand back a portion of the gains it made recently in anticipation of a cut.

Either way, the market will sift through the Fed statement for any clues about its outlook. But the bank will likely keep its cards close to its vest rather than offer a clear tone that may throw markets into a tizzy.

“One never expects clarity from central banks statements, so there will probably be enough in the statement for both the bears and the bulls,” said Wright.