PETRO LOONIE
IT MAY BE TIME FOR OIL TO REASSERT ITS INFLUENCE OVER THE CANADIAN DOLLAR.
Movements in t he currency market have a huge impact on returns, so it’s no wonder that investors like to track the Canadian dollar and its U.S. counterpart on a daily basis.
As head of global fixed income and currencies at RBC Global Asset Management, the foreign exchange market is naturally a focal point for Dagmara Fijalkowski. Her team collectively manages approximately $ 60 billion in fixed income assets — roughly two- thirds of which are Canadian, the rest global.
RBC GAM changed its policy for global fixed income portfolios back in 1999, when it started to fully hedge its foreign currency exposure back to the Canadian dollar. Despite the fact that the loonie was in the midst of a constant period of weakness, the change didn’t have anything to do with direction. Rather, as Fijalkowski pointed out, it had more to do with the firm’s approach to risk management.
Volatility in the forex market often means people are investing in what is essentially a currency fund, when they intended to put their money in a bond fund. RBC GAM sought to solve that problem.
The firm’s policy on hedging still allows portfolio managers like Fijalkowski to take active positions when she has strong views on a currency’s performance versus the Canadian dollar.
“That matters so much more now that interest rates are so low, and it’s difficult to add value calling the direction of interest rates,” she said. “The critical part is that when we open up that currency risk, we do it in a very deliberate, and size- controlled way.”
For the past two years in the RBC Global Bond Fund, for example, the non- hedged portion of the portfolio fluctuated between two and 15 per cent. The remainder was fully hedged to the Canadian dollar, something that Fijalkowski noted enabled the portfolio to keep its low-volatility attribute.
Currency markets move in cycles, and for most, the bull market in the U. S. dollar began in 2011. Six years into that cycle, Fijalkowski believes we’re closer to the end than the beginning.
However, she acknowledged the challenges with pinpointing that end- point, because looking back at previous highs in the greenback ( 1985 and 2002) shows that it peaked at different points compared to various currencies.
“We’ve seen significant weakness in the U. S. dollar, so I am not so sure,” Fijalkowski said. “But when I think about the Canadian dollar, I worry that there is going to be another few years of it being more often on the weak side of fair value.”
The first half of 2017 was an extremely favourable period of surprising growth, much more than the Bank of Canada had anticipated. That contributed to a sharp rally in the loonie, and the BoC took advantage by normalizing monetary policy slightly. But when Fijalkowski looks ahead to what could generate a positive surprise like that again, she has a tough time finding something.
“I worry that a lot of the good news had been priced into that appreciation, and we have some longer- term factors on the horizon that will not be positive for Canadian competitiveness,” she said.
That includes minimum-wage increases, the negative impact changes to housing market regulations will have on consumer spending, and the need to attract foreign direct investment flows to fund Canada’s current account deficit.
“Household spending has certainly been fuelled by the appreciation of the housing market and the significant leverage of households,” Fijalkowski said. “But it seems highly unlikely that we can count on another 20-percent appreciation in Toronto or Vancouver.”
Without the wealth effect from appreciating real estate, consumer spending will subside, and that’s why the BoC is hoping exports will rise on higher demand from foreign growth.
“All of this can impact the attractiveness of the Canadian economy as an i nvestment destination,” Fijalkowski said. “That’s why my bias would be to take advantage of currency strength like we had during the summer, and use a strong Canadian dollar to buy foreign assets.”
While some may assume that implies a bearish view on oil, the connection between crude and the loonie isn’t necessarily that simple.
Over the past five or 10 years, there is indeed a strong correlation. A high oil price has usually meant a stronger Canadian dollar, and a weaker U. S. dollar. However, Fijalkowski noted that an analysis of periods where oil is trading in a range, as opposed to moving sharply one way or another, shows that the loonie’s correlation to crude prices is not only inconsistent, but sometimes negative.
“It’s only when a big adjustment in oil prices economics happens that the correlation picks up, and that’s because of oil production in Canada,” she said, adding that Canadian oil producers have been hesitant to make new investment with prices hovering around US$50 per barrel.
Fijalkowski believes that sort of investment becomes attractive closer to US$ 60, but it’s at that point that shale producers in the U. S. will also want to turn on the taps.
“That would mean we don’t have that much short- term upside from here,” she said.