Currency risk and Canadian equities

By Al Emid | October 12, 2010 | Last updated on October 12, 2010
4 min read

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Assuming that a financial services equation will remain unchanged for any period of time qualifies as one of the larger mistakes that a financial executive can make in the current volatile markets. Assuming that the relationship between the Canadian and American currencies will remain stable could provide a costly example.

Dealing with currency risk and investing becomes even more complicated when projections for the relationship between the two currencies not only change frequently but vary between analysts.

The loonie ranges around 96 to 97 cents U.S. (at time of writing), a situation likely to change by the end of the year, explains Shaun Osborne, chief currency strategist at TD Securities in Toronto. The bank recently revised its year-end forecast, projecting loonie will be worth 98 cents – the earlier forecast had targeted 88 cents.

This revision followed a report of the Federal Open Market Committee on September 21, which offered a gloomy outlook for the U. S. recovery and uneasiness about low inflation. American analysts saw the Fed hinting at drastic action including quantitative easing if economic conditions failed to improve. At least one analyst suggested that it had become the U. S. dollar’s turn as “whipping boy of the currency markets again”.

“We hadn’t thought that more quantitative easing was at all likely so we had ascribed a very low risk probability to that event,” Osborne says, explaining the hefty revision. “But it seems to have become a much more central high probability risk for the next little while.”

However, TD projects that by the end of 2011 the loonie will top its American cousin, with a value of $1.02 U.S. – a change partially driven by expected belt-tightening by the Bank of Canada.

Montreal-based Interinvest Consulting sees a more dramatic difference between the two currencies and projects that the Canadian dollar will end the year at around 85 cents, according to Keane Yarish, a currency strategist. “We think it’s overvalued,” he says. Unlike TD, Interinvest did not revise its projections in the wake of the FOMC remarks.

Yarish cites commodity prices as a decisive factor that could prove him wrong. If the emerging markets’ appetite for Canadian resources increases the dollar would rise. On the flipside, Yarish suggests that lower energy prices will hold the dollar back.

George Vasic, equity strategist and chief economist at UBS Securities Canada has a different forecast, but with similar underpinnings, and projects the Canadian dollar falling to 93 cents by year-end.

Understanding currency risk means understanding why the currency moves, he says, pointing to commodity demand from developing countries as the major driver of the value of the Canadian dollar, but he suggests the dollar currently trades at a significant premium to the level actually indicated by commodity prices.

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“If you look over the long term, the trade-weighted basket of commodities has tracked the Canadian dollar very well and if you look at the current level of those commodity prices, they would point to a Canadian dollar around $0.88,” he says.

For Vasic, that suggests that the loonie is trading at a premium of between 8 and 9 cents suggesting that the recent sharp rise in commodity prices will moderate, eroding the premium.

Meanwhile, the risk aversion premium also built into the Canadian dollar will moderate, in Vasic’s estimation. He also expects the U.S. dollar to appreciate against the euro, further pushing down the loonie.

“When you add it all up, there will be a moderate downward bias in the Canadian dollar,” he says, arguing that made-in Canada factors such as monetary policy, do not really determine the exchange rate. “It is determined in the main part by activities in the developing world and how they impact on commodity prices.”

Non-starters in currency projections include the periodic speculation that the greenback will lose its status as the world’s reserve currency, a possibility too remote to figure into current forecasts, according to Yarish.

The Canadian equity investor has three main strategies available for dealing with currency risk, Vasic says. These include owning gold stocks or bullion as a hedge against disaster, since gold fares better than other assets in troubled times. The investor could buy U.S. bonds, because in times of extreme risk aversion, bond prices rise. In that scenario, the Canadian dollar would depreciate, indirectly enhancing the gain. The investor can also deal with risk by reducing portfolio holdings in resources to below the 45% TSX weighting and spreading the difference over the other 55%.

  • Al Emid is a Toronto-based financial journalist, covers insurance, investing and banking.

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