Road Cents – Currency Factors
By Michael Woods, CFP, CIM
As we explained in the June 2015 issue, there are a few ways for Canadian RVers to beat the high U.S. dollar over time. But my friends Walter and Winnie Bago don’t have time – they want to purchase an RV pad in an Arizona gated community within the next six months. Before they commit, they want to know what influences the Canadian dollar relative to the U.S. dollar; with that knowledge, they can make an “educated guess” about the best time to convert their loonies to U.S. dollars.
There are many factors that drive the loonie-U.S. dollar relationship, and we will focus on two: interest rates and global growth.
Interest rates have a significant impact on currency values. Interest earned on government and corporate bonds are a substantial portion of earnings for large institutional investors who, like most investors, are always searching for the highest return with the lowest relative risk. When these large investors find a better return and decide to invest their assets, they need to convert their funds into the home currency of the asset they are purchasing. For instance, if a German pension fund that was invested in Canadian government bonds wanted to switch to U.S. government bonds following the Bank of Canada rate cut, they would have to sell Canadian dollars and buy U.S. dollars. These types of transactions put upward pressure on the currency they are buying (in this case, USD) and downward pressure on the currency they are selling (CAD). At the time I write this, the annual return on a 10-year Canadian government bond is 1.43%, while the annual return on a 10-year U.S. government bond is 2.33%. Because of this difference in yields, institutional investors all over the world are selling their Canadian dollars (downward pressure) to buy U.S. dollars (upward pressure) in order to invest in the higher-returning U.S. government bonds, causing the loonie to fall relative to the U.S. dollar. Many things affect interest rates, such as the economic growth of a country, their creditworthiness, the political landscape and so on. So when Walter and Winnie make their educated guess about when to convert their loonies to U.S. dollars, they may want to assess whether the Canadian economy is about to get stronger than the U.S. economy, or vice versa.
For Canadians, global growth is also an important factor in our currency movements. With much of our Canadian exports being resource related (base metals, energy, lumber, etc.), the world’s demand for these products plays an important role in the movement of our dollar. Much like an institutional investor buying foreign assets, a producer buying raw materials often needs to convert their currency into the home currency of the company selling the raw material. If a Chinese battery factory wants to buy copper from a Canadian mine, they need to buy Canadian dollars first (upward pressure on the loonie). Similarly, if a U.S. refinery wanted to buy crude oil from a Canadian producer, chances are they would need to buy Canadian dollars first. Obviously, the faster the global economy is growing, the more other countries need Canadian resources for infrastructure, buildings and discretionary items, and the more they will be buying Canadian dollars and putting upward pressure on our currency.
If you or I were to invest in U.S. government bonds or buy some copper, it probably wouldn’t “move the market.” But when you consider the billions of dollars that flow through these products daily, you can begin to understand the impact they have on the Canadian dollar.
While interest rates and global growth are just a couple of the many moving parts to our currency, they are two of the bigger factors. So if you are like Walter and Winnie and have a large U.S. dollar purchase planned in the near future, and need to make an educated guess about when to buy your U.S. dollars, you may want to think about where interest rates are heading and the anticipated growth of our economy.
Michael Woods is a portfolio manager with Odlum Brown Limited
The information contained herein is for general information purposes only and is not intended to provide financial, legal, accounting or tax advice and should not be relied upon in that regard. Many factors unknown to Odlum Brown Limited may affect the applicability of any matter discussed herein to your particular circumstances. You should consult directly with your financial advisor before acting on any matter discussed herein. Individual situations may vary. Member-Canadian Investor Protection Fund.