Why the Canadian Dollar Could Outperform the U.S. Dollar in 2026: A Tale of Diverging Central Bank Policies

The Canadian dollar (CAD) is poised for a surprising run against the U.S. dollar (USD) in 2026, driven by a stark divergence in monetary policy and economic fundamentals between the two central banks. While the U.S. Federal Reserve appears set to maintain a hawkish stance, the Bank of Canada's aggressive rate-cutting trajectory could create a tailwind for CAD appreciation. Let's break down the numbers and logic behind this trade.

Central Bank Policy: A Tale of Two Rates

The Bank of Canada is projected to slash its policy rate from 2.25% in Q3 2025 to a mere 1.25% by December 2026, according to TD Economics and the Bank of Canada's own scheduleTD Economics - Latest Forecast Tables^[2]. This rapid easing reflects a weakening labor market, slowing GDP growth, and persistent inflation pressures from U.S. tariffsJune 18, 2025: FOMC Projections materials, accessible version^[1]. In contrast, the U.S. Federal Reserve's June 2025 Summary of Economic Projections forecasts a median federal funds rate of 3.50%-3.75% by year-end 2026, with a central tendency of 3.1%-3.9%June 18, 2025: FOMC Projections materials, accessible version^[1].

This widening gap in interest rates—up to 250 basis points by late 2026—could make Canadian assets less attractive compared to U.S. counterparts, but the story isn't that simple. Currency markets often react to relative policy cycles, not absolute levels. If the Fed delays rate cuts while the Bank of Canada acts decisively, the CAD could benefit from a “flight to quality” as investors seek higher-yielding assets in a slowing global economy.

Economic Fundamentals: Canada's Pain, the U.S.'s Gain

Canada's GDP growth is expected to lag behind the U.S. in 2026. The Bank of Canada now forecasts 1.1% growth for 2026, down from earlier projections, due to trade tensions and U.S. tariffs on steel, aluminum, and energy productsTrade resilience, fiscal tailwinds boost Canada’s growth prospects^[3]. Meanwhile, the FOMC projects U.S. GDP growth at 1.6% for 2026, with a central tendency of 1.5%-1.8%June 18, 2025: FOMC Projections materials, accessible version^[1]. This divergence suggests the USD could strengthen against risk-off currencies like the CAD in the short term.

However, inflation trends tell a different story. Canada's headline inflation is expected to dip closer to the 2% target by 2026 as energy prices stabilize and the CAD's strength offsets tariff-driven pressuresBank of Canada publishes its 2026 schedule for policy interest rate announcements^[4]. The U.S., meanwhile, faces a more stubborn inflation outlook, with the CBO projecting PCE inflation at 2.1% for 2026CBO’s Current View of the Economy From 2025 to …^[5]. If the Fed is forced to keep rates higher for longer to combat inflation, the USD's appeal could wane, creating a window for CAD appreciation.

Trade Balance and Fiscal Tailwinds: Canada's Hidden Leverage

While U.S. tariffs are dragging on Canada's trade balance, the CUSMA agreement shields 90% of Canadian exports from dutiesTrade resilience, fiscal tailwinds boost Canada’s growth prospects^[3]. This partial insulation, combined with the Liberal government's fiscal stimulus (tax cuts and defense spending), could boost Canadian growth by 0.3 percentage points in 2026Trade resilience, fiscal tailwinds boost Canada’s growth prospects^[3]. These fiscal tailwinds may offset some of the drag from trade tensions and support the CAD.

The U.S. trade balance, though not explicitly modeled in the data, is likely to remain in deficit as domestic demand outpaces export growth. A weaker U.S. trade position could limit the USD's upside, especially if global demand for American goods softens.

The Bottom Line: Positioning for Divergence

Investors should watch the Bank of Canada's rate cuts and the Fed's inflation fight as key drivers of CAD/USD dynamics. A 1.25% Canadian rate versus a 3.75% U.S. rate by late 2026 would create a significant yield differential, but the CAD's potential to outperform hinges on two factors:
1. Speed of Fed Rate Cuts: If the Fed delays cuts, the CAD could rally on relative easing.
2. Trade Policy Resolution: A reduction in U.S. tariffs would ease pressure on Canada's economy and trade balance, bolstering the CAD.

For now, the data suggests CAD is undervalued relative to its fundamentals. A long CAD/short USD position, hedged against sudden rate hikes in the U.S., could pay off handsomely in 2026.