Dealing with currency volatility

It helps to step back for a moment and remind ourselves what is behind currency volatility. In its purest form, the definition of an exchange rate is the price of one currency in terms of another currency. Thus, volatility in any one currency may be the result of something happening in the home country (in this case, Canada), or in the country of the other currency (the United States). In addition, when you are comparing your currency to a major international currency such as the U.S. dollar, currency volatility may reflect world-wide changes in economic or financial conditions.

The recent volatility in the Canadian dollar contains elements of all three. Within Canada, the likelihood of a fairly decent economic recovery, the prospects of the federal government deficit being eliminated in the next few years and anticipated increased demand for Canadian-produced commodities all point to a higher Canadian dollar. In the United States, continuing uncertainty about the strength of the recovery (despite a strong third-quarter start) and the ability of the U.S. federal government to make a sizeable dent in its budget deficit are contributing to weakness in the U.S. dollar and concurrent strength in the Canadian dollar.

From a global perspective, some governments are said to be favouring other currencies than the U.S. dollar when adding to their international currency reserves. A second global issue affecting currencies is the question of whether, despite the fact that credit markets are now working well, the multitude of problems that cropped up among financial markets and financial institutions have been permanently dealt with. A third is the likelihood that the patterns of economic growth – i.e. which countries and sectors will lead – may be different this time from past recoveries.

It is also helpful to have some idea of what is behind the current bout of currency volatility, though it is safe to say that most advisors and their clients would be much happier to hear that governments or their central banks can control or reduce it. Unfortunately, for currencies such as the Canadian dollar that are “floating” currencies, the options are limited. The fact is that these currencies are driven more by markets and less by the policies of individual governments or their central banks. Investors who dislike currency volatility do have a friend in Mark Carney, Governor of the Bank of Canada. More specifically, Governor Carney dislikes currency volatility when the result is a sharply rising Canadian dollar. The Bank of Canada Governor might also be concerned about a sharply-falling Canadian dollar but that is a topic for a different column.

A sharp run-up in the currency is a concern because exports are really important to Canada – over the past five years, exports of goods and services have averaged around 38% of Gross Domestic Product, a much higher percentage than in the United States, or Japan and roughly in line with China. Mr. Carney dislikes a rapidly-rising Canadian dollar because it makes Canadian exports more expensive to American buyers. Normally, when a Bank of Canada Governor concludes that the Canadian dollar is rising too fast or too much, he would have three options: lower interest rates in Canada, talk the Canadian dollar down or intervene directly in international currency markets by selling enough Canadian dollars into the market to lower its price. With a benchmark interest rate of 0.25%, the first option is not in the cards at the moment.

The Governor has already used the second option – talking the dollar down – bolstering it with some strong words that the rise in the Canadian dollar could completely offset the beneficial effects to the economy from other current trends. The Bank of Canada added an economic forecast that shows the potential adverse effects on the Canadian economy down the road from the rise in the dollar. This was effective, driving down the Canadian dollar in late October. Governor Carney has threatened to intervene in currency markets but this third option would be more effective if such intervention was coordinated among several other central banks. In the final analysis, however, if global currency markets are really determined to drive up the Canadian currency, they are likely to ultimately have their way.

Some currencies are tightly controlled, specifically some of the Asian currencies. The likelihood though of that sort of control being imposed on the Canadian dollar is next to none. So, we need to think about how to deal with currency volatility rather than looking to the possibility that it will be controlled or eliminated.

Our distaste for currency volatility comes from the damage it can do to our clients’ non-Canadian dollar investments, for example, a client who has good-performing U.S. dollar assets but whose Canadian-dollar returns on those assets are damaged by a rising Canadian currency. Even clients who have benefited when the opposite occurred, tend to be much more conscious of currency-related losses than currency-related gains.

How should we deal with currency volatility? The most obvious solution is to invest exclusively in Canadian-dollar denominated securities. The problem with this approach is that it limits your clients from benefiting from investment opportunities around the world. The “invest in Canada only” approach can be fine-tuned, however, to investing in Canadian securities that are likely to benefit directly from positive developments around the world such as increased global demand for commodities such as energy that are produced in Canada.

A second approach is to invest outside of Canada, picking investments whose potential returns are likely to more than offset any adverse effects of currency volatility. A third approach is to hedge the Canadian dollar. This can be done directly (the more complicated approach) or indirectly by purchasing securities with a built-in hedge such as “currency-neutral” mutual funds. It is important to remember that there is always a cost to hedging but that in a period of high currency volatility, that cost can be significantly less than the potential loss from currency volatility, especially over the short-term. A final point here is that the old and well-tested rule that it is difficult to successfully time the equity market applies in spades to currency markets. A long-term approach is recommended and if the investor follows this advice, he or she may well find that currency fluctuations have a tendency of offset one another.

In the final analysis, dealing with currency volatility is much like successfully coping with so many other investment uncertainties. The trick is not to be overly concerned with forecasting the future or looking for ways to avoid the volatility but rather to accept that it is going to happen and to adjust the investment strategy accordingly.

Peter Drake is vice-president, retirement & economic research, for Fidelity Investments Canada. With over 35 years of experience as an economist, he leads Fidelity’s research efforts in examining retirement in Canada today.