Uncertain Future of the Canadian Dollar
Dwight Mann - Nov 27, 2018
Despite the fact that the US and foreign markets have been strong and have substantially outperformed the TSX, this currency move has in the short-term impacted the value of these holdings. For example if an investor’s portfolio has a 25% US/foreign weighting, this recent jump in the Canadian dollar would represent an overall portfolio drop of 2.5%, even with the US stocks holding steady.
Even with devaluation of US assets from the big Canadian dollar jump, it has still paid off to be diversified. We feel that this recent jump in the Canadian dollar represents a good opportunity for investors who are underweight in foreign assets to broaden their approach and increase US and European exposure.
The big question at this point is: Can the Canadian dollar go much higher?
Exactly how high can the Canadian dollar go, now that the Bank of Canada has made its first hike in over seven years? The direction of the dollar will depend on expectations of future rate hikes. The Bank of Canada appears to be trying to get ahead of the curve anticipating a tightening of the labour market, despite the fact that inflation is still below the target level of 2%. This may turn out to be a big gamble on the economy.
In recent years a substantial amount of growth can be attributed to real estate. According to Philip Cross from the Fraser Institute, Ontario’s housing market contributed 30% of the province’s income growth in 2016, versus 5-7% historically. 2 Ontario’s economy can’t continue to rely primarily on housing for this growth. The Bank of Canada has intended its low interest-rate policy of the past few years to ignite the manufacturing sector in Ontario. Cheap borrowing costs, a low Canadian dollar and low oil prices were meant to spur investment in jobs and factories. Unfortunately this hasn’t happened, as unintended consequences of policy have led to a housing bubble instead of getting an export-led boom.
Higher Bank of Canada rates will not only negatively impact US investments in Canadian dollar terms, but will also hit borrowers. In a highly leveraged economy the recent rate change will increase borrowing costs and may create headwinds for economic growth. Debt-fueled consumption has continued to push Canadian household debt past record levels. Higher level of debt servicing is likely to work against economic growth, as less disposable income will be available to spur the economy through consumption. Negative pressure on the Canadian dollar would come as a result.
So rather than an interest rate reflecting the light at the end of the tunnel, it may instead be a train coming our way. With Canadian households carrying significant mortgage debt, the Bank of Canada’s rate hike could also pose a risk to the Canadian housing market. Much has been said over the last few years about a potential Canadian housing correction. Each rate hike brings that correction ever closer. If Canada’s housing market does begin to unravel as a result of higher interest rates, all bets on the Canadian dollar are off.