High Rates a ‘Boon’ for Active Currency Investors

October 17, 2023 11 min 8 sec
Michael Sager
CIBC Asset Management
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Welcome to Advisor ToGo, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject matter experts themselves.

Michael Sager, deputy chief investment officer, multi-asset currency management at CIBC Asset Management.

The first topic to discuss is how interest rates and the broad interest rate environment are affecting currencies. I think there’s two perspectives here.

The first one is that higher interest rates and also wider interest rate differentials between currencies are absolutely a boon for active currency investors. That is, investors who look to add value to client portfolios through taking active positions, long short positions in various currencies around the world. Interest rates are one of the key drivers of currency direction, currency returns. So if you have wider differentials, you have more opportunity to add value. If we look at interest rate differentials today, we are pretty close to two-decade highs. So that tells you that, at least from this perspective, an interest rate perspective, the opportunity to add value to investor portfolios from decision-making in currencies, position taking in currencies, has not been this attractive for a long time.

Second one is a broader macro context. Market participants certainly didn’t expect policy interest rates to rise as quickly as they have over the past 18 months, nor did they expect them to rise to the levels they’ve reached. And I think the same goes for bond yields too. A lot of that rise has reflected resilient growth in the U.S., but nonetheless, it’s now getting to levels or rates and yields are getting to levels where they’re adversely affecting market sentiment, and that in turn is adversely affecting some of the more pro risk emerging market currencies.

The U.S. economy has remained more resilient in terms of economic activity. Both more resilient than market participants expected in absolute returns, but also relative to other major economies. So it’s the U.S. economy that is the primary driver of higher-for-longer from central banks. It’s the U.S. economy that’s driving yields to levels that were not expected even six months ago. And so given that it’s the U.S. economy that’s in the driver seat, this is very positive for the U.S. dollar.

Although we do expect the dollar to be stronger for the next three to six months, one of the most strong currencies, it’s not going to appreciate so much that it has a really significant bearing on economic outcomes. Oftentimes, a strong dollar will impact import and export demand in other countries. A strong dollar will materially impact the outcome that various countries experience in terms of inflation. That’s certainly in play at the margin, but much more important at the moment is just the general tightness of central bank policy around much of the global economy.

Europe is in a recession, and there the European Central Bank has a quandary. Economic activity is weak and weakening, but inflation is converging back to target much slower than expected. So inflation is too high, which is why the European Central Bank is keeping policy tight, higher-for-longer. But that has important implications for deepening further the economic recession.

China has experienced very disappointing economic growth over the last six months related to particularly structural problems in its domestic housing and property market, but also high levels of indebtedness at the local government level. So China is doing something completely different to other major markets. It’s stimulating growth, or at least trying to, via policy easing. So as I say, that’s very different to the U.S., to Europe, to Canada, other developed market economies, where higher-for-longer in terms of tight policy is the norm.

So what can investors do with that information to benefit portfolios?

Well, certainly we think that it’s beneficial to include active currency as an investment allocation within portfolios. Currency markets are very liquid, active currency returns are very diversifying, and active currency mandates are unfunded. They’re implemented via forward contracts that don’t require, in most cases, initial margin payments. So the mandate is very capital efficient. It’s unfunded, which is very different from most other investment mandates.

So what about the Canadian dollar, the loonie? What is its outlook in the next three to six months? Our bias is to think that the Canadian dollar will be weaker against the U.S. dollar over this time horizon for a few reasons. One, the Canadian economy doesn’t look as resilient as the U.S. economy. GDP growth data over the past couple of quarters has been less positive, less strong for Canada than it has been in the U.S. The Canadian housing market continues to look extremely overvalued, and productivity in the Canadian economy has been negative since prior to the Covid pandemic.

Productivity is really important because it’s a key element in the attractiveness of currencies. Their ability to attract capital flows. The most productive economies are the ones that attract the strongest capital flows. So Canadian productivity being negative for a number of years now is not positive for inward capital flows into Canada, which is not positive for the Canadian dollar.

So whether it’s from a more secular trend, that would be the productivity story, or a more cyclical trend, relatively weaker GDP growth, a vulnerable housing market, the outlook for the Canadian dollar against the U.S. dollar is not particularly bright over the next three or six months.

One of the key inputs in that outlook also is the price of oil. Canada’s a big producer and exporter of oil, so in periods where oil price is strong, that’s helpful to the Canadian dollar. And in periods where oil prices weaken off, of course, the opposite is true. Over the past couple of months, we’ve seen some strength in the price of oil, which by itself would’ve been supportive to the Canadian dollar. But if you put it together with all of those other factors, GDP growth, housing, productivity that I mentioned earlier, the net is not particularly attractive.

Going forward, we do think that underlying growth trends in the global economy, including in the U.S., will weaken off. We expect a mild recession for the global economy over the next year or so. That’s not positive for the price of oil. So we think probably we’re at or about the peak for the time being and the price of oil, and we are likely to see a little decline from here. That will add to the relatively negative view on the Canadian dollar in the short term.

All of that said, much longer term, we think that the U.S. dollar is very expensive, and that the Canadian dollar will recover. But that’s a longer term, one, to two, to three-year view.