Jan. 5 (Bloomberg) -- Canada's dollar rose above 78 U.S. cents for the first time in almost 11 years as investors snapped up Canadian short-term debt on speculation the central bank will cut interest rates at its Jan. 20 meeting. The two-year bond had its largest percentage gain since Dec. 12.

A strengthening currency makes exporters' goods more expensive in the U.S., their primary market, and hurts economic growth. The Canadian dollar surged 21 percent in 2003, its largest increase since 1951, when the Bank of Canada began recording foreign-exchange data, as international investors bought Canada's higher-yielding debt.

``The market is seeing a rate cut as a reaction to a stronger Canadian dollar -- it's cause-and-effect,'' said Reid Farrill, executive director of currency sales at CIBC World Markets Inc. in Toronto. Policy makers will place ``continued emphasis on the manufacturing sector and the impact of the Canadian dollar on exporters.''

The Canadian currency rose to 78.01 U.S. cents at 5 p.m. in Toronto, the highest since May 1993, from Friday's 77.64. A U.S. dollar buys C$1.2819.

The two-year bond, which is most sensitive to interest-rate changes, rose 7 cents to C$100.07, yielding 2.96 percent. Canada's benchmark 10-year bond fell 9 cents to C$103.47, yielding 4.79 percent, on worries that a rate cut could spark inflation and reduce the value of interest payments.

The Jan. 20 meeting is the ``primary factor'' that could stall the Canadian dollar's recent rise because the market has already factored in a cut of 25 basis points, Farrill said. A basis point is 0.01 percent. The currency may rise to 80 U.S. cents, or C$1.25 per U.S. dollar, in the first quarter, he said. It rose 3.7 percent during the past two weeks.

Dodge Comments

Bank of Canada Governor David Dodge said on Dec. 8 that policy makers weren't sure if rates were low enough to underpin a ``robust'' Canadian economy. Dodge said he would watch for evidence of Canadian growth ``solidly'' above 4 percent before the Jan. 20 meeting.

Canada's gross domestic product grew 1.1 percent in the third quarter, half the pace economists had expected. A government report in December showed Canada's GDP posted the first two-month advance in October since February, increasing 0.2 percent for the month. By comparison, the U.S. economy grew 8.2 percent in the third quarter.

Canadian exporters continued to suffer in November from a rising currency that reduced earnings from auto and lumber sales to the U.S. and increased the cost of raw materials, according to today's monthly report on factory prices. Barring currency gains, the factory prices index would have risen 0.1 percent instead of declining 0.4 percent.

Deflation

``The No. 1 story is that despite strength in raw materials prices, the strength in the Canadian dollar pushed down industrial prices,'' said Douglas Porter, senior economist at BMO Nesbitt Burns in Toronto. ``Effectively this means there is no finished-goods inflation in Canada, it's actually deflation.''

Today's yield on the banker's acceptance contract due Feb. 16 fell 3.5 basis points to 2.49 percent, down from 2.81 percent on Nov. 18. The spread between the overnight rate and the future's yield suggests investors expect the Bank of Canada to lower its benchmark overnight lending rate a quarter percentage point to 2.5 percent at its Jan. 20 policy announcement.

The Bank of Canada's 2.75 percent overnight lending rate is 1.75 percentage points more than the Federal Reserve's rate.

Canada's yield advantage has been shrinking as traders effectively priced in a ``100 percent chance of a rate cut'' in the first quarter, Porter said. The Canadian two-year bond yields 1.04 percentage points more than the two-year Treasury note, down from as high as 1.14 percentage points last week. The rate advantage was 1.85 percentage points in mid-2003.

Bernanke

Canada's dollar may rise to C$1.24 in a few months, a level last reached in March 1993, based on recent trading patterns, said Junya Tanase, a Tokyo-based currency strategist at J.P. Morgan Chase & Co.

The currency rose earlier as weekend comments from Federal Reserve Governor Ben S. Bernanke fueled speculation the U.S. won't take steps that would diminish Canada's interest-rate advantage.

Bernanke said the risk of a U.S. currency crisis is ``quite low,'' suggesting the Fed will leave its target interest rate at a four-decade low of 1 percent well into this year. Economic reports in Canada in recent weeks have pointed to stronger growth, which may mean the Bank of Canada won't reduce its benchmark rate as much as expected in coming months.

Commodities

``Bernanke's comments made it clear that the Fed is far from concerned over broad U.S. dollar weakness,'' said Sean Callow, a currency strategist at IDEAglobal, a research firm in New York. ``Canada's dollar continues to remain one of the preferred ways of playing the U.S. dollar's weakness, because of the yield advantage over the U.S.''

Traders also bought Canadian dollars today in response to growing demand for commodities, Farrill said.

Canada's dollar should post further gains from rising commodities prices, according to a Lehman Brothers fixed-income research report released today titled ``Global Relative Value.''

``Although commodities and many commodities-sensitive currencies rose sharply in 2003, we believe that this trend is far from over,'' the report said. ``In our view, a further rise in base metals prices and manufacturing will me most beneficial for the Australian and Canadian dollar.'' Energy and metals companies comprise 30 percent of Canada's benchmark stock index.

Employment Report

Policy makers will pay close attention to Friday's unemployment rate and net change in employment in December, Callow said. While Porter agreed, he didn't think the Bank of Canada would change its expected stance at its Jan. 20 meeting unless the reports were stronger than anticipated.

``We'd have to see something above 50,000 jobs generated for the Bank of Canada to be swayed,'' he said. Economists expect an unemployment rate of 7.5 percent and an addition of 25,000 jobs, according to the median of estimates in a Bloomberg survey.

Statistics Canada will also announce December's Ivey index of purchasing managers Wednesday.

Last Updated: January 5, 2004 17:10 EST