Canada dollar edges above U.S. dollar; highest since 2008

TORONTO (Reuters) - The Canadian dollar briefly pushed above parity with the greenback on Tuesday for the first time since July 2008, but slipped back to end the day just below the one-for-one level.

Powered by rising commodity prices and an economic rebound that investors expect will soon trigger interest rate hikes, the Canadian dollar climbed as high as C$0.9988 to the U.S. dollar, or US$1.0012, after firmer economic data helped fuel investor demand for commodity-linked currencies.

The currency finished at C$1.0012 to the U.S. dollar, or 99.88 U.S. cents, up from Monday's finish at C$1.0028 to the U.S. dollar, or 99.72 U.S. cents.

The currency has risen more than 5 percent against the U.S. dollar so far this year after gaining almost 16 percent in 2009.

The currency's rise has been supported by Canada's healthy fundamentals relative to the United States and other struggling Western economies, as well as by the improving global economic outlook.

All these factors suggest the currency's strength may be more sustainable than when it last traded at par with the greenback about 20 months ago, said George Davis, chief technical strategist at RBC Capital Markets.

"The backdrop is basically pointing to a market that is looking for growth and expansion in terms of the economic cycle. That backdrop is lending itself very well to the Canadian dollar," Davis said.

"We've had, on balance, stronger than expected economic data here in Canada, especially when we look at GDP, retail sales and employment, and that has a lot of people in the market more convinced that the Bank of Canada is going to act ahead of the (U.S. Federal Reserve) in terms of raising interest rates."

CONDITIONAL RATE PLEDGE TO EXPIRE

The Bank of Canada has made a conditional pledge to hold its key interest rate at a record low of 0.25 percent until the end of June, provided inflation stays tame. But market players have begun to price in an earlier rate hike as the economy heats up after the recession.

Yields on overnight index swaps, which trade based on expectations for the Bank of Canada's key policy rate, suggest rates will have risen by at least 25 basis points by July.

The currency's march higher intensified around the release of Canada's February employment data on March 12 and bond yields rose on expectations of rate hikes, Davis said.

Canadian money market yields were slightly lower on Tuesday.

"The bond market is flat today. It really hasn't reacted to the currency," said Sheldon Dong, a fixed income analyst at TD Waterhouse Private Investment.

"The rate hike expectations have been baked into the market. Technical trends have been indicating the Canadian dollar would be hitting parity. That's already been built in. There's just no fresh news."

Canadian bonds mostly underperformed their U.S. counterparts, with the 10-year yield narrowing to 27 basis points from around 32 basis points on Monday.

Market watchers said last week's U.S. payrolls data was an added boost to an already positive economic backdrop. The report on Friday showed employers in the United States, Canada's largest trading partner, created jobs in March at the fastest rate in three years as private firms stepped up hiring.

That also followed stronger Canadian gross domestic product data for January.

Strategists will now turn their gaze to Canadian employment data for March, which is due on Friday.

"(The currency has) been heading toward parity for weeks and it was inevitable. There's no surprise," said Jon Gencher, director of foreign exchange sales at BMO Capital Markets.

"This time seems to be a more of a sustainable move. I think for the next little while, we are certainly going to hover around parity," he added.

HOW HIGH CAN IT GO?

The Canadian dollar reached parity with the greenback in 2007, for the first time since the 1970s, climbing to a modern-day high of US$1.1039 that November.

It last traded at par with the greenback on July 22, 2008, weakening as investors flocked to the safe haven of the U.S. dollar during the worst financial crisis since the Great Depression.

But it likely won't rise as high as the November 2007 level, said Davis, who sees it peaking at US$1.03.

There were several unique factors related the currency's ascent in 2007, he added.

"There were a lot of M&A flows that were working their way through the market and that was propping up the Canadian dollar. That I think caused an overshoot. I don't think we have similar factors in place at this point in time ," Davis said.

The Canadian currency could also face several headwinds as the Fed begins raising U.S. interest rates, possibly in the last quarter of 2010 or the first quarter of next year, he added, drawing investors to the greenback.

Steve Butler, director of foreign exchange trading at Scotia Capital, said the currency's rise might not keep pace with tighter monetary policy.

"Quite often you see that, once the rate hikes start, the currency doesn't keep up with the interest rate hikes. That may be the bubble that bursts," he said, adding that he sees the currency peaking anywhere between US$1.05 and US$1.06.

"It's going to be a slow and steady grind rather than an accelerated move from these levels."

(Additional reporting by London FX desk; editing by Rob Wilson)