INTEREST RATES: Dollar rise hints at central bank interest rate hike sooner than later

The Canadian dollar hit a 10-month high Monday amid growing risk appetite and rising expectations that inflation will ultimately force the Bank of Canada to break its promise to keep interest rates on hold until mid-2010.

"The time for tightening is not yet at hand, but June 2010 seems too late," said Yanick Desnoyers, the assistant chief economist at National Bank Financial. "The day when the condition for the bank's low-rate commitment is no longer met will probably come before then."

Desnoyers said the benchmark interest rate had been lowered to a record low of 0.25 per cent to limit the damage of the recession and financial crisis. However, he said the rate was too low relative to core inflation, which stood at 1.9 per cent in June, just one basis point below the bank's target rate.

The outlook for higher interest rates, whether they come sooner or after June next year, has helped support the Canadian dollar, which has increased by about eight per cent since the beginning of the month.

The dollar inched up 16 basis points to 92.50 cents US on Monday after reaching its highest level since October in intraday trade. The rise was boosted by an improvement in investor sentiment after new U.S. home sales surged by 11 per cent in June and the three-month Libor rate, the benchmark borrowing rate banks generally charge each other, fell to a record low 0.496 per cent.

The decline in Libor, which peaked at 4.82 per cent in October, is a sign that credit pressures continue to ease. Commodity prices were also marginally higher amid expectations of an uptick in demand.

Aron Gampel, vice-president and deputy chief economist at Scotia Capital, said the Canadian dollar has also strengthened against the greenback because of concerns that U.S. stimulus efforts would leave behind a problematic debt hangover. He said the loonie was likely on its way back to parity with the U.S. dollar.

With the Bank of Canada having declared last week that the recession is likely over, interest is beginning to turn to when interest rates will begin to rise. Some, such as Desnoyers, believe the Canadian recovery, bolstered by government stimulus, will push inflation up faster than expected, forcing the Bank of Canada to use its "get out of jail free card" and raise the benchmark policy rate before June 2010.

The central bank said it would keep interest rates on hold until June 2010 "conditional on the outlook for inflation."

Bond yields have risen in recent weeks and now suggest a 90-per-cent chance of an interest rate rise within nine months.

Others, such as Gampel, believe the central bank will keep interest rates on hold until mid next year, but embark on an aggressive tightening thereafter. However, he said the economy was at a turning point and the Bank of Canada's ultimate decision would depend on the speed of economic recovery.

"They could be looking at having to push interest rates up at a faster rate, and sooner, if the recovery takes on a greater scope going forward," Gampel said.

He said the recovery could well be on track to outpace expectations as businesses rebuild inventories, consumer spending picks up and fiscal stimulus kicks in.

However, he said evidence to date does not suggest the central bank will need to hike rates before June, particularly with a large amount of excess capacity in product and labour markets.

(prepared by Alia McMullen/Financial Post )