The Canadian dollar strengthened on Wednesday after the Bank of Canada kept its policy rate unchanged at 2.25%, while its messaging signaled greater concern over the inflation outlook than markets had anticipated, according to MUFG Global Markets Research in a note.
The shift was notable given the benign underlying inflation backdrop for July, said the bank in a Thursday note.
Wednesday's "communications were certainly indicative of a possible rate hike coming much sooner," wrote MUFG's Head of Research, Global Markets, Derek Halpenny in the note.
The BoC removed its reference to the current policy stance being appropriate for achieving its inflation target and placed greater emphasis on upside inflation risks, he added. In particular, it flagged a "heightened risk" that higher energy prices could spill over into broader inflation measures.
Governor Tiff Macklem also played down the ongoing growth impact from US tariffs, noting their relatively narrow base. With activity proving more resilient, the BoC may now see upside inflation risks outweighing growth risks, according to MUFG.
The two-year yield rose 8 basis points, providing support to the Canadian dollar, but MUFG doesn't expect a sustained rebound at this stage. The bank's valuation model and the divergence between USD/CAD and the two-year swap spread suggest the pair is trading below fair value, with 1.40-1.41 a more appropriate range.