Portfolio power: Foreign exchange

Currency relationships are affected by a wide range of factors. These include interest rates, inflation, fiscal policy, monetary policy, trade balances and capital balances, along with unexpected events such as trade wars, military conflicts and commodity shocks. However, for the purpose of this article, we focus on cyclicality — the risk exposure of currencies to the global economic cycle.¹ Being aware of this cyclicality can help investors decide whether to accept or hedge currency risk. The following table shows currency cyclicality. We divide currencies into 4 different groups, based on how currencies tend to move with the global economic cycle.

Table 1: Currency cyclicality

Counter-cyclical currencies like the Japanese yen, Swiss franc and U.S. dollar have tended to move in the opposite direction of the global economic cycle, gaining value in crashes while losing value in recoveries. In crashes, for example, global investors have tended to move assets to U.S. Treasury bonds in a “flight to safety,” strengthening the U.S. dollar. Counter-cyclical currencies are from developed markets that investors perceive to be safe havens.

Mid-cyclical currencies like the British pound, Chinese yuan and euro have not tended to move strongly with or against the global economic cycle. Other examples of currencies in this group include the Indian rupee and Singapore dollar. Mid-cyclical currencies are from developed markets or major emerging markets. This group of currencies includes most developed markets that are not obviously counter-cyclical or pro-cyclical.

Pro-cyclical currencies like the Australian dollar, Canadian dollar and New Zealand dollar have tended to move in the same direction as the global economic cycle,– losing value in crashes while gaining value in recoveries. Pro-cyclical currencies are from developed markets that depend heavily on natural resources.

Super-cyclical currencies like the Brazilian real, Russian ruble and South African rand have tended to move in the same direction as the global economic cycle, but with even more gusto than pro-cyclical currencies — sharply losing value in crashes while sharply gaining value in recoveries. Super-cyclical currencies are from emerging markets.²

These currencies have behaved differently in the past, while they will likely continue to change over time. As such, these are not hard and fast rules about how currencies will move but rather trends of how currencies have tended to move in recent decades, particularly during crashes and recoveries in the global economy.

Let’s explore the decision to hedge the currency exposure of foreign stocks, returning to the view of currency cyclicality in Table 1.

The Canadian dollar is a highly cyclical currency. The Canadian dollar’s cyclicality — or risk exposure to the global economic cycle — is somewhere between that of a developed market and an emerging market. This reflects a currency whose value is influenced by global demand for oil, gas and other natural resources.

In a global economic crash, counter-cyclical and mid-cyclical currencies have tended to be less risky than the Canadian dollar. This makes a case for Canadian investors to accept the currency risk of foreign stocks in these currency groups, since this exposure may reduce rather than increase portfolio risk in a global market crash. However, Canadian investors may choose to hedge the currency risk of stocks in the super-cyclical group, since this exposure may increase portfolio risk in a global market crash.

To summarize, assume a Canadian investor holds 3 global stock funds: United States, developed markets and emerging markets.³ Based on currency cyclicality, a Canadian investor would consider accepting the currency risk of U.S. stocks and developed markets stocks, while hedging the currency risk of emerging markets stocks. However, currency cyclicality is only one of the factors to consider when managing foreign currency exposure in a portfolio.

We’ve outlined a general principle of accepting currency exposure for currencies that are less risky than an investor’s domestic currency, while hedging currency exposure for currencies that are more risky than an investor’s domestic currency. If this makes sense for stocks, why would it be any different for bonds?

The reason is that stock returns are typically larger than currency moves. For example, major stock markets might return 10% annually over the long term, while an annual move of 5% to 10% between major currencies would be relatively high.

The same is not true for bonds. For example, major bond markets might return 3% to 5% annually over the long term. This is lower than a currency move of 5% to 10%. Sometimes these moves can be more extreme. In the global financial crisis, for example, the U.S. dollar gained about 22% against the Canadian dollar in 2008 and lost about 13% in 2009.⁴ Since investors hold bonds to provide stable cash flow and reduce the portfolio risk of holding stocks, they do not typically want to expose themselves to the risk of a large currency loss on their bond position. As a result, investors tend to hedge the currency risk of foreign bonds.

This decision can be different if the foreign bonds are in a less risky currency than the investor’s domestic currency. For example, Canadian investors may not fully hedge the currency risk of U.S. bonds. The U.S. dollar is the global reserve currency and has tended to gain value against other currencies during major crashes. By accepting currency risk on part of their U.S. bond position, Canadian investors may attempt to reduce portfolio risk when the global economy crashes. However, this can increase portfolio risk when the global economy recovers.

So far, we’ve considered 2 points in currency management: the cyclical differences between currencies and the asset class differences between stocks and bonds. We reiterate these first 2 points and add 3 others. These points, taken together, help to round out the decision whether to accept or hedge currency risk.

Currency cyclicality

Investors may be less concerned about currency moves if foreign currencies have less cyclical risk than their domestic currency.

Asset class

Investors may be less concerned about currency moves in stocks than bonds.

Time horizon

Investors may be less concerned about currency moves if investing for the long term, since currency fluctuations may roughly balance out over periods of several decades. However, currency moves can be hard to predict over months or years. The shorter an investor’s time horizon, the stronger the case to hedge foreign currency exposure.

Liabilities

Investors may be less concerned about currency moves if their foreign investments match their foreign liabilities, like holding U.S. dollar assets while also maintaining a vacation property in the United States. However, investors may be concerned about currency moves if they mostly hold foreign investments but mostly have domestic liabilities in Canadian dollars.

Position size

Investors may be less concerned about currency moves if foreign assets are a small part of their portfolio.

Table 2: Currency checklist

We summarize these points in a currency checklist:

The more points an investor checks in the “Bias to accept currency risk” column, the stronger the bias to accept foreign currency risk. For example, if an investor holds currencies with less cyclical risk than their domestic currency, owns more stocks than bonds and has a long time horizon, then the investor may have a relatively strong bias to accept foreign currency risk.

The more points an investor checks in the “Bias to hedge currency risk” column, the stronger the bias to hedge foreign currency risk. For example, if an investor has a short time horizon, domestic liabilities and a large position in foreign assets, then the investor may have a relatively strong bias to hedge foreign currency risk. 

We’ve outlined a strategic approach to manage foreign currency exposure. We compare this to a tactical approach, where investors update their currency exposure based on the latest political or market developments. In a tactical approach, for example, an investor would accept foreign currency exposure on a U.S. stock fund when they believe the U.S. dollar will rise against the Canadian dollar, say because of a trade war. In the opposite case, an investor would hedge foreign currency exposure on a U.S. stock fund when they believe the U.S. dollar will fall against the Canadian dollar, say because international stocks are expected to outperform. As these examples suggest, currency moves can be hard to predict. For a forecast of the USD–CAD exchange rate, typically going out 18 to 24 months⁵, consult the CIBC Economics research hub Opens a new window..

Investors may find that a strategic approach is easier to implement than a tactical approach, since their investments and objectives will likely change less frequently and abruptly than the moves of foreign currencies against the Canadian dollar. Investors who want to systematize their approach can include a brief statement about how they will manage currency risk, as part of their investment plan.

Currencies have varying levels of cyclicality or risk exposure to the global economic cycle. Currencies can be counter-cyclical, like the U.S. dollar; mid-cyclical, like the euro; pro-cyclical, like the Canadian dollar; or super-cyclical, like the Brazilian real. The cyclical exposure of the Canadian dollar is somewhere between that of a developed market and an emerging market.

Deciding whether to accept or hedge currency risk depends on a number of factors. These include:

• whether the foreign currency exposure has lower or higher cyclical risk than the investor's domestic currency
• whether the foreign currency exposure is in stocks or bonds
• whether the investor has a long or short time horizon
• whether the investor's liabilities are foreign or domestic; and
• whether foreign assets make up a small or large part of the portfolio.

While investors can manage currency risk strategically or tactically, a strategic approach is likely easier to implement. Investors who want to systematize their approach can include a brief statement about how they will manage currency risk, as part of their investment plan.

¹ For example, refer to the World Bank, Currency cyclicality: Emerging markets rhetoric and the Euro crisis Opens a new window.

² Not all emerging markets have super-cyclical currencies. As noted, the Chinese yuan and Indian rupee are mid-cyclical currencies, due to the size and diversity of their economies. Some emerging markets, particularly in the Middle East, peg their currency to the U.S. dollar at a fixed rate, while other emerging markets use capital or exchange rate controls to reduce currency volatility.

³ Developed markets are also known as EAFE, representing developed markets in Europe, Australasia and the Far East. EAFE includes counter-cyclical currencies like the Japanese yen and Swiss franc; mid-cyclical currencies like the British pound and euro; and a small weight in pro-cyclical currencies like the Australian dollar and New Zealand dollar.

⁴ Refer to the Federal Reserve Bank of St. Louis, USD–CAD exchange rate Opens a new window..

⁵ Refer to CIBC Economics research hub Opens a new window.. Under the Forecast Snapshot section, select View All Rates & FX. This opens a document titled “Forecast update”. The document provides forecasts of interest rates and the USD–CAD exchange rate, typically for the next 18–24 months.