Currency market volatility has risen over the last several weeks with US dollar strength and Canadian dollar weakness significant. This document looks at the recent fall in the Canadian dollar and implications for Canadian investors.
Currency market volatility has risen over the last several weeks with US dollar strength and Canadian dollar weakness significant
The Canadian dollar has fallen approximately 10% relative to the US dollar so far in 2020 due to plummeting oil prices, uncertainty surrounding Coronavirus, and the US dollar safe haven status
The Canadian dollar has only been this low once in the past seventeen years; in 2016 the Canadian dollar briefly fell below US $0.70
The fall versus other major currencies, including the Euro, British Pound and the Yen, has also been significant
Canadian dollar weakness has softened the blow from the sharp virus-driven losses of Canadian investors’ unhedged foreign currency exposures; investors with currency hedged positions have not benefited from this windfall and also face cashflow and rebalancing issues
Investors who can withstand short-term volatility may wish to consider hedging a portion of their US dollar exposure, which is typically the largest foreign currency portfolio exposure
Continue reading below to learn more.
Whilst the recent focus of financial markets has been primarily on the impact of the Coronavirus on equity markets, where volatility has exceeded historical highs, the virus’ impact on other markets should not be ignored. Currency markets have been strongly impacted. Currency volatility, which has been low for years, has also risen sharply.
The US Dollar surges on widespread risk aversion
The initial reaction to the Coronavirus was one of US dollar weakness as US rates were expected to be cut whilst other currencies were supported by very limited ability to cut rates given their already low levels. However, as the threat of the virus intensified, the dollar turned around in mid-March and the Dollar Index is now close to its 2016 high as it benefits from being the world’s major transactional currency.
The US dollar’s rally has pushed several currencies to multi-year lows, including the British pound, the Euro, the Australian dollar, the New Zealand dollar, and the Canadian dollar.
The Canadian Dollar falls to multi-year lows
Since the start of the year, the Canadian dollar has fallen by approximately 10% relative to the US dollar. At the end of March, the exchange rate was hovering around US$0.70, levels which have only briefly been breached once since early 2003.
The Canadian dollar also lost ground against other major currencies so far in 2020. Most notably is the loss against the Yen (approximately 10%), but losses also occurred relative to the British Pound and the Euro.
This situation is a reversal from 2019 where the Canadian dollar gained value against almost all major currencies.
Drivers of Canadian Dollar weakness
There are two main drivers to the recent fall in the Canadian dollar relative to the US dollar:
- Soaring demand for the US dollar as a safe-haven asset has been driven by the economic impact of the Coronavirus. This has pushed other currencies, including the Canadian dollar, lower.
- In March the Canadian dollar faced significant downward pressure due to plummeting oil prices resulting from the initiation of a price war between Russia and Saudi Arabia. The West Texas Intermediate Crude Oil Index is down over 60% year to date. As a petroleum exporting currency, the Canadian dollar is highly correlated to oil prices, as seen in the following chart.
For Canadian investors, the sudden weakness of the Canadian dollar in 2020 has various ramifications.
- Canadian dollar weakness is acting to soften the blow from the sharp virus-driven losses of unhedged exposures to foreign currencies, especially the US dollar. On a year to date basis, hedged US equities have been significantly more negative relative to an unhedged position.
To March 31st, the S&P 500 Index is down 12% from the start of the year in Canadian dollar terms, compared to a fall of 20% in US dollar terms, which does not benefit from Canadian dollar weakness. To put this into dollar perspective, if an investor had $100 invested in US equities at the beginning of the year, the investment would be currently be worth $8 more on an unhedged basis ($88 versus $80).
- Investors with currency hedges implemented by forward foreign exchange (FFX) contracts will need to pay out losses when the contracts expire which requires careful consideration of which asset is best to sell if cash reserves are not at hand with all markets suffering from lack of liquidity. Investors who implemented hedging through shifting from unhedged share classes to hedged share classes do not face this cashflow challenge. It is worthwhile remembering that FFX contract payments are offset by increases in the spot currency moves from the underlying asset which effectively means that investors are just not benefitting from the boost to equity values from a weaker Canadian dollar.
- Investors with direct currency hedges (not implemented through the share class route) in particular will have seen a currency hedge ratio increase above target as their equity holdings’ values have fallen. Questions about whether to rebalance currency hedges back to target arise.
Our view on the Canadian Dollar
The US dollar will continue to act as a safe-haven currency until virus fears subside which makes increasing US dollar hedges quite risky at this stage. However, the Canadian dollar has fallen to cheap levels relative to its historic value. The chart below shows the Canadian dollar against a broad range of trading partners, adjusted by inflation, which gives an indication of long-term value.
We do not suggest that investors with hedges in place should lift their hedges at these levels. We do not envisage that there will be much further Canadian dollar downside, although a poor virus scenario would mean that the Canadian dollar could fall further relative to the US dollar. Nor do we suggest that currency hedges that have grown versus underlying loss-making assets should necessarily rebalance their hedges.
We think it is likely that the Canadian dollar will appreciate over the medium-term once the virus is overcome. Investors who can withstand short-term volatility, and particularly those with no currency hedging already in place, may wish to consider hedging a portion of their US dollar exposure (including US equities and private assets). Currency markets are moving quickly and therefore investors may want to set some pre-determined trigger points for entering into hedges, as well as for exiting the strategy. We would advise a gradual approach given volatility and further downside risk in the near term.
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