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Investing.com -- The Canadian dollar is projected to experience a choppy trajectory through 2026 before firming up in 2027, supported by domestic policy measures and economic spillovers from the United States. According to a recent Morgan Stanley note, the CAD is positioned to outperform currencies such as the Swiss franc, the British pound, and the euro in the medium term due to a mix of internal investment, Bank of Canada (BoC) tightening, and growth dynamics.

Morgan Stanley economists expect a recovery in Canadian growth in the second half of 2026, though the momentum is likely to be outpaced by a stronger U.S. expansion that keeps USD/CAD near the upper end of its range. A transition from a “Bear Regime” to a “Carry Regime” environment gives the Canadian dollar room to recover into 2027 as policy tightening by the BoC and U.S. demand bolster domestic prospects.

In the near term, the CAD is likely to find upward pressure from the compression in U.S.-Rest of World (RoW) rate differentials, which makes it less costly for global investors to hedge USD exposure. This technical factor, combined with the relative inflation trajectories and labor market recoveries, results in diverging monetary paths, where the Federal Reserve is likely to further ease while the BoC remains on hold.

“Canada and the US are both battling persistent inflation, but only Canada’s labor market has seen a recent recovery,” the note read. The divergence plays into CAD strength until mid-2026, though a reversal is expected as U.S. growth accelerates and the Fed halts its easing cycle. From that point, the strengthening greenback places renewed pressure on CAD in the back half of the year.

While Canada’s economy recently cleared a crucial hurdle in approving its 2026 budget, the anticipated business incentives in the bill are unlikely to fully materialize until later next year. Despite the promise of increased fiscal spending, Morgan Stanley noted that investors should remain cautious heading into 2026 given the lagging effect of policy benefits and relative economic underperformance.

Relief for CAD takes shape in 2027, Morgan Stanley said, bolstered by a likely rate hike from the BoC during the first half of the year, and a reinvigoration of investors’ confidence. Supporting this optimism are expected improvements in Canadian exports and a stimulative fiscal backdrop, further amplified by sustained U.S. growth spillovers.

Key risks to this outlook remain, particularly if the U.S. growth trend falters or geopolitical tension escalates over the future of USMCA. “Investors beginning to express concern about the dissolution of USMCA would weigh disproportionately on CAD, like we’ve seen in past periods of US-Canadian uncertainty,” Morgan Stanley cautioned.