Currency: Unhedged

Currency has clearly become a hot topic over the past few months as the loonie rose materially against the U.S. dollar, bucking a multi-year trend. We visited this topic a number of times recently including reports titled Oil, C$ & Yields and Has the C$ Turned?.

In this edition of Ethos, we will revisit our expectations and views on the USD/CAD, how we recently closed our short-term currency hedge, and why we typically embrace currency exposure.

Our View on Currency

We still like U.S. dollar exposure. The recent rapid rise in the loonie appears to have been driven by a confluence of factors that may prove fleeting over time.

That being said, it certainly took us by surprise. There is no doubt the Canadian economic data has improved, and this emboldened the Bank of Canada to begin a tightening cycle for the overnight rate. We do wonder if this would have transpired had the Bank of Canada known the U.S. Fed was about to start talking more dovish. The data had softened in the U.S., creating this environment for a rapid rise in the loonie.

This relative economic performance can be easily seen in the two-year spreads between Canada and the U.S. In early June, U.S. yields were 60 basis points higher than Canada. Today, they stand at only 10 bps.

Will CAD Continue to Strengthen?

You can’t argue with the data; it came out very positive for the loonie. However, looking six months out or longer, we just are not sure it will continue. The Canadian economy remains very sensitive to movements in the housing industry, which has started to show some cracks.

We also continue to be cautious on the price of oil. Oil has taken a back seat to the economic data as a driver in the exchange rate, but it still has influence. The data in the U.S. has been softer, but appears to have started regaining momentum. Expectations for U.S. tax reform are now very low, opening the door for a potential positive surprise. NAFTA talks as well may not be very positive for the Canadian dollar.

From a fundamental perspective, the C$ does not appear to be undervalued anymore. Could we move into overvalued territory? Of course, anything is possible. Political turmoil in the U.S. could cause selling of the U.S. dollar or a fumbling of the next debt ceiling issue. However, these are not our baseline expectations, and at 79 – 80 cents, we simply see greater value in U.S. exposure.

Portfolio Changes

As a result, we closed our currency hedge in the Redwood Core Income Equity Fund. This fund can hold up to 35% U.S. securities.

The Canadian equity market is very concentrated in a few sectors, and we use our U.S. allocation to improve diversification into sectors lacking in Canada. We typically don’t hedge the currency exposure, but decided in late April to hedge one quarter of our U.S. holdings from a currency perspective.

We closed the hedge in the early days of August as the economic data appears to be starting to change momentum and the number of speculators who have moved from shorting the loonie to being long appears overdone. In our opinion, the Canadian dollar moved too far, too fast.

Longer-Term Currency Exposure

Currencies are often a zero-sum game over the long run, especially between the currencies of well-developed economies. While things can stay out of whack for quarters or even years, there are gradual forces that correct disequilibrium.

A country’s currency that rises too far will become less competitive, slowing the economy and gradually bringing the currency back down. Alternatively, a low currency may attract more foreign acquisitions from a value perspective. While this may be true in the long run, the short run is certainly volatile.

The chart below is the S&P 500 and MSCI EAFE Index returns during the past two months, year-to-date and over the past twenty years (annualized). The last two months, translating back to Canadian dollar, have sucked all the positive performance away. Even the year-to-date numbers look much less impressive. But notice how close the 20-year local and Canadian dollar returns are. A few basis points – probably not worth the trouble of hedging in the long term.

USD: A Good Diversifier for Canadians

There is another reason to embrace the U.S. dollar: it is a good diversifier for Canadians. Okay, follow us here. U.S. dollar exposure is a negative when the Canadian loonie is rising against the U.S. dollar. Given that global investors view Canada as a resource country, the loonie does best when global growth is accelerating, which has been the case this year.

When global growth is healthy, our markets do really well too. So, as a Canadian investor, your Canadian investments are thriving, but your U.S. holdings are a bit of a drag due to the currency. Think of this as insurance. When global growth slows, or due to some geopolitical hot spot, the market turns and becomes more risk averse. That has a negative impact on our market, but is often good for the U.S. dollar.

The U.S. dollar is viewed as a safe-haven currency and during times of turmoil, money flows to the U.S. During times of turmoil, it is not good for global-growth-levered markets such as ours. So when times are bad, having exposure to the U.S. dollar acts as a partial buffer. Hence, it is a good diversifier for Canadians and generally, we believe investors should be unhedged.



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Charts are sourced to Bloomberg unless otherwise noted

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