Why the Loonie's Slide Is Really a Dollar Story

The next driver is interest-rate differentials. The preference for USD assets and widening rate differentials are mutually reinforcing. Stronger demand for U.S. exposure helps explain the direction of the move. The growing U.S. rate advantage has made that preference more durable and intensified the pressure on currencies like the loonie, according to the analysis.

With the start of the war in the Middle East and the push higher on inflation, market expectations for Fed policy changed sharply. Markets priced in the possibility of Fed rate hikes. That was a sharp reversal from the prevailing sentiment prior to the conflict, which had been that the Fed would be the lone central bank reducing interest rates in 2026. The prior expectation for spreads on borrowing costs between the U.S. and other countries to narrow quickly reversed. The shift is most evident in short-term interest rate spreads between the U.S. and Canada and Germany.

The result of the policy divergence is that spreads vis-à-vis the U.S. on two-year government debt have widened by 25 basis points for Germany and 40 basis points for Canada in the first half of 2026. The smaller change in Germany reflects a recent hike from the European Central Bank. The Bank of Canada has opted to stay on the sidelines. The widening premium to hold U.S. assets over other countries has helped lift demand for the dollar, at the expense of the loonie and euro, according to AlphaScala's analysis.

The outlook for the loonie turns on whether those interest-rate gaps begin to narrow. AlphaScala's baseline scenario expects U.S. inflation and growth to moderate in the coming months, allowing the Fed to gradually reduce the fed funds rate to 3.25% in 2027. That would take some pressure off the CAD by lowering the relative return on U.S. dollar assets.

The main risk is that the U.S. economy proves strong enough to keep those rate differentials wider for longer, according to the analysis. There are two ways this could happen. The first is a more cyclical scenario. The energy shock fades. U.S. demand remains firm enough to leave the economy in excess demand. In that case, the Fed would have less room to cut rates without risking renewed inflation pressure.

The second risk is structural. The productivity gap between the U.S. and its peers does not narrow back toward historical norms. Stronger productivity growth can allow the U.S. economy to sustain faster growth and higher real rates without generating the same inflation pressure. If that advantage persists, the neutral rate in the U.S. could settle higher than in Canada and other advanced economies.

The recent data point in that direction. Since 2020Q1, U.S. output per worker has grown by 2.0% annualized, compared with 1.3% in the 20 years before the pandemic. Canada and other G7 economies have fallen further behind, held back by weaker capital deepening, softer business investment, and other structural headwinds. Stronger U.S. productivity growth helps explain how the economy has continued to outperform despite materially higher interest rates, according to AlphaScala's analysis.

The implication for CAD is straightforward. If stronger U.S. productivity keeps the neutral rate higher, the Fed may not need to deliver as much rate relief as markets currently expect. U.S. short-term rates would remain elevated relative to Canada, preserving the yield advantage that has already helped pull capital toward U.S. assets.

That would leave the loonie vulnerable even if domestic conditions unfold broadly as expected. AlphaScala's baseline still points to some CAD recovery as U.S. rates eventually move lower. A sustained U.S. productivity advantage would delay that adjustment by keeping rate and growth differentials tilted in favour of the dollar.

Under that scenario, the appreciation expected through the rest of 2026 and into 2027 would likely fail to materialize, according to the analysis. Two-year spreads vis-à-vis the U.S. have widened by 40 basis points for Canada in the first half of 2026.