Summary: The USD has risen significantly lately against most currencies, including the CAD. There are many economic/yield reasons for this move, with the biggest being USD strength ahead of potential election uncertainties. Yet at 72 cents, the CAD may be getting too cheap.
There are so many things that are great about being Canadian, and one of them is the US dollar (USD) or, more specifically, the impact of USD exposure on Canadian portfolios. It is a natural diversifier for Canadians because it most often behaves as a safe haven currency, while our home currency and market are not. Given our resource tilt, the Canadian equity market is more sensitive to future global economic growth expectations. And so is our currency (CAD). Meanwhile, the USD is viewed as a safe haven currency, in part because when trouble hits, Americans move their cash/investment closer to home, often driving the USD higher.
Given this almost natural diversification benefit of USD exposure for Canadian portfolios, we generally don’t hedge the currency for our US investment holdings. The exception to this general rule is when the CAD gets too weak (or USD gets too strong), and we may do some partial hedging. So, at 72.2 (1.384), is it weak enough?
There are some excellent reasons the CAD is at 72 cents. The Bank of Canada cutting 50bps while expectations for future Fed cuts keep moderating due to stronger economic data. Today, the Fed Funds is at 5%, and the market is “pricing-in” between 5-6 25bps cuts by the end of 2025. That compares to 8 cuts priced in a mere month ago. Canada is already down to 3.75% with 4-5 cuts by the end of 2025. This is all just near-term economic data momentum. The Citigroup Economic Surprise index for the US has been rising and now sits at +20 compared to -44 two months ago. Canada was +4 two months ago and is now -13. One economy is picking up vs expectations, the other is slowing.
Add that all up, and the two-year yield differential between Canada and the US is now at extreme levels. Two-year yields are often viewed as the better indicator for currency pairs compared to overnight lending rates. That spread is more than 1%, and oil prices have been trending downward, creating a further headwind for the CAD.
But wait, there’s more. Speculators, based on futures positioning, are betting heavily against the CAD. And then there is the election, the US election, that is. There is a common occurrence ahead of US elections for the USD to strengthen. It doesn’t always occur as there are many moving parts in currency markets, but as election day approaches, USD often goes up. Likely money coming back to the safety of the USD just in case something goes awry. Making this not completely a CAD/USD thing, but more general USD strength against all others. For Canadians, the USD is up 3% this month; for Japanese investors, it's up 6%.
That all sounds pretty grim for the loonie, doesn’t it? But that is also why it is down at 72 cents today. Purchasing Power Parity is a model that rarely works, comparing the purchasing power in one country to the next based on the exchange rate. Yet the farther it gets away from the zero line, the stronger the attraction or mean revision becomes. Today, things cost much less in Canada than in the US. That attracts capital, that attracts tourism, that attracts acquisition interest, etc. Add all that up, and your currency will likely start to appreciate.
Our Thoughts
So the CAD is cheap, and the USD is expensive. Add to this highly negative futures positioning and the fact global growth is actually pretty good. Decent or improving global economic growth is usually positive for CAD and negative for USD. If it were not for a close US election in a little over a week, we would be getting really excited about hedging USD exposure. Everyone seems to be talking about contested election risk and added uncertainty. There is also the scenario where the election is resolved with less uncertainty, which could easily see the CAD snap back and rebound higher.
— Craig Basinger is the Chief Market Strategist at Purpose Investments
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Sources: Charts are sourced to Bloomberg L. P.
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