Hello and welcome back to the Institutional Insights Podcast, where we discuss interesting and relevant topics for institutional investors. My name is Haley Hopwood. I'm a portfolio manager with PH&N Institutional and your host. Today we're going to be talking about the Canadian dollar. We're going to discuss some of the recent moves, or lack thereof, and some of the near-term influences that we're watching, and then provide a view on fair value of the Canadian dollar over the more medium to longer term. And, to help us navigate through this topic, I am joined by an expert in this area, Dan Mitchell. Dan is managing director and senior portfolio manager on our RBC Global Fixed Income and Currencies team, and is very well equipped to answer any question as it relates to currencies. Dan, welcome. Thank you so much for joining me.

Thanks for having me, Haley. It's good to be here. I'm thrilled that there's actually some excitement about currencies.

Perfect. Okay. So first, why don't we step back and review what's happened in 2024 so far. So, Canada has been underperforming the U.S. economically for quite some time. This has led to the Bank of Canada delivering more rate cuts compared to the Fed. And one might have expected to see some Canadian dollar weakness versus the U.S. dollar. But it hasn't really been the case. Can you talk about why that's been?

Yeah, I think, you know, I think there's a couple of reasons. Part of the story is just this lack of overall market volatility. It's not as though we've had a shortage of market moving themes. This has been a big election year, both in the U.S. and in emerging markets. Fiscal tailwinds we've seen this year that have supported that theme of U.S. exceptionalism. Some geopolitical events, trade wars. There's lots going on. And these things could create some volatility. But when it comes to the actual fluctuations that we've seen in developed market currencies, things have been pretty quiet. We look at the euro, for example, and I'm mentioning the euro–U.S. exchange rate simply because it's the biggest and most important currency pair by volume and influence – that exchange rate’s been stuck in a 7% range since early 2023.

That's rare for FX. You know, we normally talk about currencies and think about them as being volatile, and an asset class that could be swayed by pretty much anything, from politics, geopolitics, we mentioned weather, economic developments, commodities, central banks. So, you know, almost two years without much movement? It's really unprecedented.

In Canada, we see the same behaviour a little closer to home. The Canadian dollar has been trading more or less sideways between 1.32 and 1.40 for that same two-year period. And it's even kept to an even much tighter 2-point range between 1.36 and 1.38 for most of the summer. So, you know, part of that lack of CAD weakness, it's just simply because FX markets aren't moving.

The other reason is that, for now, currencies seem to have been grouped into different categories. We've got European currencies, there's the Asian complex, Latin American currencies have sort of been in their own world. The Loonie fits into this North American grouping. And it's seen as a bit of a mini-U.S. dollar. And I guess that kind of makes sense given that, our Canadian economy is pretty closely tied to the U.S. economy, and we've definitely benefitted to some extent from the stronger U.S. economy.

So, you know, absent any external influences or CAD-specific developments, the two currencies, the U.S. and Canadian dollars, tend to move side by side, and that might explain a little bit of why the Loonie has been so rangebound, over the past couple of months. In the past, those big external influences, they‘d be things like big shifts in risk sentiment, oil price movements, or a divergence in central bank policy. And I think just to come back to your question, I think it's worth spending a little bit more time on that last one, because the divergence in central bank policy is one of the major determinants of exchange rates, historically. It just hasn't been a big driver of the Canadian dollar this year because the Fed and the Bank of Canada have largely been moving in the same direction. They were both hiking, throughout 2022 and 2023 and then they had this sort of cutting bias this year. So, one of the biggest historical drivers of exchange rates hasn't yet really been a deciding factor for the Canadian dollar this year.

Okay. So yes, both central banks are in cutting mode now, but it's fair to say that the Bank of Canada has and is expected to continue proceeding much more aggressively. Does that start to have an impact at some point, or should we expect more of the same from the CAD/USD relationship?

Yeah, I do think that monetary policy will start to factor in a lot more. The Bank of Canada got an earlier start to its rate cutting campaign and part of the reason why the Canadian dollar has started to soften a little bit in recent weeks, toward the weaker end of its range.

Just as a side note, we're going to be talking about the Canadian dollar. I wanted to mention market convention trades a little bit differently than how we read about the Canadian dollar in the papers. So when I say that the CAD is near the weaker end of its range, I'm really referring to a stronger dollar-CAD exchange rate. So, a stronger dollar, a weaker Canadian dollar. And just for context, right now, dollar-CAD is trading at around 1.38. That's very near the CAD-weaker/U.S.-dollar-stronger end of the range between 1.32 to 1.40.

So, you know, we've got, slightly easier monetary policy in Canada than the Fed. And looking forward, the Bank of Canada is expected to continue cutting rates at a faster clip. Right now, markets are pricing six full cuts in Canada between now and June, versus only four and a half in the U.S. And just this week, we've seen a number of investment banks start to change their forecasts for more aggressive cutting in Canada, so 50-basis-point moves at each of the next two meetings – in October, that's next Wednesday (October 23th, 2024), and at the December 11th meeting as well.

So in terms of currency market drivers, that’s maybe not as powerful as the full divergence of these two central banks going in opposite directions. But it's enough that currency traders are starting to factor in a preference for holding the U.S. dollar, over the Loonie.

And so, you know, we might see the Loonie drift a bit weaker from here as a result. But it's already close to that weaker end of the range that we talked about. So, there isn't likely to be a massive move on this difference in rates.

All right. Let's move on to something that has historically been a significant driver of Canadian dollar moves, both up and down, which is oil prices. We used to observe a fairly tight correlation between the Canadian dollar and oil prices, but it seems like that correlation is no longer quite as strong. For instance, if we look between 2020 and 2022, oil prices moved up pretty dramatically through that time – WTI went from $42 a barrel to $77 per barrel, and the Canadian dollar didn't really change a whole lot through that period. Can you help us understand this change in dynamic?

Yeah, it's an interesting concept. It just speaks to the dynamic nature of currency markets. You know, different factors come in, and matter at different times. It can be a fun and frustrating element of trading currencies, those constantly shifting drivers that just keeps us on our toes. For years, oil used to be one of the most important variables for the Loonie, but now hardly has an impact at all. And that correlation has dropped, as you mentioned, quite significantly since the late 20-teens.

To understand why, I think it helps to sort of break down the two main ways that stronger crude prices help the Canadian economy, because that really is the mechanism for the currency: what strengthens the economy, strengthens the currency. First, and I think most intuitively, is what we call the terms of trade impact. The idea that the price of what Canada exports is rising faster than the price of the goods and services that Canada imports. Because Canada is a net exporter of oil, rising crude prices benefit the economy through that channel. The second channel, though, is far more important, and that's the business investment. So higher crude prices really should encourage companies to start plying more capital into building new wells, new oil sands facilities, new pipelines, new refining capacity. That involves hiring people, who tend to spend more of their hard-earned money on goods and services.

And that whole process, from business investment to more employment to higher wages to greater consumer spending, that's all very positive for the economy. The reason that CAD, we think, has sort of lost track with the oil prices, is because the second of those two channels isn't really happening.

You know, instead of building new capacity, these Canadian oil firms are returning capital to shareholders through higher dividends and share buybacks. They're not spending on CAPEX. They're no longer hiring as many people. And from what our Canadian equity colleagues tell me, it's partly because that's what Canadian investors are demanding. It's a way of keeping company executives from making irresponsible investment decisions and keeping them from growth at any cost. It's in part because, you know, greater supply in Canada doesn't necessarily help unless you can get that oil out of the country at a reasonable price. And, you know, there was lots of talk a couple of years ago about the heavy crude discounts that Canadian companies got for their oil. And then lastly, it's partly because there's so much uncertainty out there of the future of heavy oil for them to really commit capital for these 20-, 30-, and 40-year projects. So, the bottom line, even though that terms of trade channel still works, it's the added jobs and the capital investment that's really the bigger driver for growth.

And without that stuff happening, you know, Canadian dollar traders aren't really paying heed to oil prices at this stage. As I said, though, you know, drivers come and go. So, you know, it’s worth keeping oil on our radar.

Right. Okay. That's very interesting. And, you know, kind of speaks to the state of the overall Canadian economy as well on this issue of productivity that we're dealing with, but we can save that for another time. I did have a follow-up to this topic though, and it relates to just the conflict right now that we're seeing in the Middle East. It's been heating up over there and in the event that things escalate further, this could put upward pressure, on oil prices. The extent of that pressure is debatable, but maybe for the sake of this question we’ll assume that it does push oil prices higher. Based on what your response was to this previous question, does it mean that we should expect very limited impact to the Canadian dollar?

Yeah. You know, it's a good question. Sometimes maybe what you need is a shock to kick those old correlations back into line. And I certainly wouldn't be surprised to see a spike in oil prices on the back of the Middle East tension. But, like a short-term spike isn't really likely to stoke that long-term business investment that we talked about a minute ago.

Because by definition, it's a spike, it's a short-term move in oil prices. And, you know, just playing the devil's advocate here, I actually think there's an argument for saying that higher oil prices might actually be negative for CAD. And that's because CAD is a pro-cyclical currency, it's tied to some extent to the U.S. economy and to global growth in general. And so high and sustained oil prices would be bad for global growth and so, I think would end up denting the Loonie’s prospects.

A bigger escalation in the Middle East would also be – just as a side note – bad for overall equity market sentiment and, you know, the Loonie does trade in line with stocks and does tend to falter when stocks sell off.

Right. Okay, interesting, and not what I was expecting to hear. Okay. So why don't we pivot now to something on everyone's minds? The U.S. presidential election, which is fast approaching, now at this point weeks away. Appears to be quite a tight race, and so maybe you can talk about some of the potential impacts to currency markets if Trump wins versus Harris.

Yeah. You know, we've read a lot on this topic, as you’d imagine. And most commentators are thinking that the U.S. dollar would rally following a Trump win, while a Harris victory would see the greenback fall. The rationale here is that Trump's proposed tax cut extensions and deregulation, would be good for economic growth and potentially extend this period of U.S. exceptionalism.

He's also proposing large tariffs on goods and that translates into higher inflation for the U.S. and higher rates in the U.S. So again, dollar supportive. I do think that the knee jerk reaction of the dollar-stronger move on a Trump win would be the right interpretation, but that's kind of only part of the story because what matters much more for us, and for our clients, of course, is the longer-term outcomes.

We know that the dollar is already extremely overvalued. We liken that to sort of this elastic band of valuations being super stretched. So if the dollar does rally in the short term, it's going to have a tough time staying elevated for very long – you know, it's hard to stretch that elastic band much further.

I wouldn't be surprised to see something similar to what we saw in 2016 if Trump did win the election. Back then, the dollar rallied by about 7% over the course of a couple of months through the end of the year. And then it spent the following year falling by 15%. So, net net, the dollar actually weakened.

And sorry, is that the U.S. trade-weighted dollar or is that versus the Canadian dollar?

That's the U.S. trade-weighted dollar, yeah.

Okay.

You know, importantly, from a longer-term perspective, both candidates propose fiscal plans that are unsustainable in the long term. Neither one would do much to slow the very large current account deficits that the U.S. currently runs. And those are two areas where the U.S. really relies on foreign funding. And they're putting that foreign funding to the test these days with record issuance of U.S. debt. So, you know, we're bearish on the longer term on the dollar, and I think we'd see different versions of dollar weakness in 2025 regardless of who lands the White House.

Right. Yeah. And I guess we'll have to just wait and see for a couple of weeks to see how that shakes out. I think how Congress ends up will be a big determinant in how strong these policies can end up being.

How does the CAD fare in all of this? You mentioned the Trump tariffs that he would potentially impose, 10% blanket tariffs, that’s obviously negative for America's trading partners. How much of an impact could that have on the Canadian dollar?

Canada's a big trade economy, an export-oriented economy. I think no doubt tariffs on Canada would definitely be negative. And so far the policies – you know, blanket tariffs on everybody, 60% tariff on China in particular. So, of course negative for the Canadian dollar.

We mentioned, this 1.32 to 1.40 range in the Canadian dollar. The Loonie’s already trading at the weaker end of that range, the dollar-stronger end of that range. I think if we saw some weakness in the Canadian dollar beyond 1.40, it would be very short lived. I think probably in the terms of North America, there will be other countries that will be targeted a little bit more. Given the focus on China, I think Mexico would probably be a bigger target than Canada would in that calculus.

Okay, perfect. That makes sense. So we're getting close to the finish line here, but maybe before we just tie things up, let's move the focus towards the future. I know you've touched on it a couple of times, but let's dig into it a little bit deeper, and perhaps you can talk about where you think the Canadian dollar settles versus the U.S. dollar over the medium to longer term.

Yeah, I mean, we started this podcast by talking about how quiet things have been in foreign exchange. But of course that doesn't mean things are going to stay that way. And in some sense, you could argue that conditions are actually pretty coiled right now. And that bigger exchange rate movements are in the cards. I talked, for instance, that this valuation, this elastic band of stretched valuations. It's not just the dollar that's very expensive, but it's the it's all the other, major G10 currencies that are extremely cheap, including the Canadian dollar. I'd also argue that positioning is stretched. Now, it's notoriously tough to sort of gauge positioning in the over-the-counter markets because it's not like we have a stock exchange to go to see all that record of trades. FX is a very decentralized market.

But we do have some metrics that show longer term investors are heavily overweight US bonds. And heavily overweight U.S. tech stocks. Not surprising given higher yields in the U.S. and tech's multi years outperformance. Any reduction or capitulation in those positions would be strongly dollar negative as money starts to flow back to home destinations in Europe and Japan.

Those moves, I think, would be further stoked by Fed cuts or softer economic growth. So, you know, a recession in the U.S. would be one of the more negative scenarios for the greenback, I think.

Getting back to your question, though. You know, we're expecting, the US dollar to weaken over the next couple of years. Most other G10 and EM (Emerging Markets) currencies, I think would benefit from that U.S. move. The Canadian dollar will definitely be among those that rally, but probably one that underperforms other major currencies, in part because of the Bank of Canada's faster cutting rate cycle. From the Canadian investor perspective, we think this is a good time to be hedged against the U.S. dollar exposure, but again, we're less concerned about exposures to other global currencies like the British pound, Japanese yen or euro, because those currencies will benefit more from this falling dollar than the Loonie will. And just for context, you know, we've penciled in high single digit gains from the euro and yen when measured against the greenback, but only a 5% gain from the Loonie.

Okay. Excellent. Very helpful information. Alas, this is not going to help me in time for my Maui trip in November here. But maybe next year, U.S. travel will be a little bit more affordable for everyone.

Dan, I want to say thank you so much for taking the time to join the podcast today and share your wealth of knowledge on this subject. It's much appreciated.

Thanks, Haley.

And thank you to all of our listeners out there for tuning in to today's episode. Hopefully you found the discussion insightful, and if you do have any follow up questions, please reach out to your Institutional Portfolio Manager. Take care everyone.

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