The Canadian dollar is breaking through parity again and has been described by currency traders as the “master of the universe.” So is this a good time to revisit currency-hedging programs?
It is typical to equate Canadian dollar strength to prospects for the material and energy sectors (a “commodity” currency). But historical analysis also suggests that the Canadian dollar is a play on equity markets in general and the Canadian financial sector in particular.
In their paper Global Currency Hedging, authors John Campbell, Karine Serfaty-de Medeiros and Luis Viceira confirm our suspicion that as long as the U.S. dollar is the global reserve currency, its performance will be inversely related to global equity markets. For a Canadian investor with global equity exposures who wishes to reduce overall portfolio risk, this means that the U.S. dollar should not be hedged.
Certainly the U.S. dollar shows no sign of being toppled from its perch as the world’s reserve currency. Europe is in disarray, Japan is still rebuilding, and China appears to be heading for a “soft” landing.
But Canada continues to parlay its strong economic fundamentals into a good international news story:
- there have been record-breaking purchases of Canadian debt by foreign investors—$32 billion of money market and $96 billion of longer-term bonds at last count;
- Canada’s banks were named the soundest in the world in 2011 by the Financial Stability Board for the fourth consecutive year;
- Canada’s strong resource sector is making Canada “less sensitive to shocks” than other markets, according to PIMCO; and
- Canadian pension funds are respected as long-term investors with strong internal investment capabilities, as noted in the Mar. 3 issue of The Economist.
With all these tailwinds, the prospects for the Canadian dollar may be stronger than ever before!
As for active currency management, indexes in foreign exchanges are now being set up to take advantage of standardized trading signals (carry, momentum and valuation). The structure of these indexes is transparent, and rebalancing is accommodated using standardized algorithms. In addition, the indexes are customizable so they can be selected to fit any fund’s preferred currency management objectives. Dynamic currency management has never been so easy or so efficient.
It may indeed be time for an overhaul of both currency hedging and active currency management for your pension fund.