Returning from a trip to the United States, many Canadians feel the shock of the low Canadian dollar when they receive their credit card statements. After exchange, the Big Mac you bought on your US road trip was more expensive than if you got one down the street in Canadian dollars. Shouldn’t it be the same price? Why does the US feel “more expensive”?

The concept of “Burgernomics” was created by the Economist magazine in the 1970s and led to the “Big Mac Index”, which tracks the prices of Big Macs around the world and addresses the concept of purchasing power parity (which posits that the price of a good should be the same in every location, and if it is not, it will pressure exchange rates to adjust accordingly). They’ve found this isn’t always the case. So, what leads to the fluctuation in currency and how does it impact a Canadian investor's finances—besides the premium for a road trip burger?

Currency risk is important for investors to be mindful of as investment portfolios have an increasingly global reach. Fluctuations in foreign exchange rates can impact the currency risk of a portfolio and there are a few key factors that can affect foreign exchange rates—mainly, inflation, interest rates and a country’s trading activity.

Inflation

I’m sure we’ve all heard our beloved grandparents reminisce with stories of “back in my day... I could buy this in a store for a penny”. Whether they intended to or not, your grandparents provided a quintessential example of the effects of inflation.

Inflation measures the rate at which the average cost of a commonly purchased basket of goods and services increase over time. The increase in the price of this basket broadly impacts the increase in prices of goods and services across a country, and can impact consumers negatively if prices are increasing but wages are not.

Inflation does not only impact consumers, but it can also decrease the purchasing power of a currency as a whole. Generally speaking, when comparing inflation between countries, the country with the lower inflation rate tends to see their currency gain value.

It is evident from the chart below that the US and Canada have consistent inflation levels driving their currency value.

Because US and Canadian economies are so intertwined, so are central bank inflation targets. Central Banks, like the Bank of Canada and the Federal Reserve, aim to maintain an inflation target to maintain price stability within a country. This is important when we think of the connection of prices charged for goods and services and wages for example. If prices were rapidly inflating or deflating and wages did not have a chance to keep pace, consumers would struggle to maintain their purchasing power, budgets, debt, and savings levels—essentially their entire financial house.

Price stability gives society greater confidence in the value of their dollar. Essentially, consumers know what they can spend and save with more confidence. This price stability, via inflation, is maintained through interest rate policies that impact inflation targets.

Interest rates

Comparing interest rates between countries is another pertinent factor in assessing a given foreign exchange rate. Higher interest rates tend to attract foreign investors, which typically increases demand for the local currency.

We can think of this concept in two ways, interest rates are:

• what you pay (to borrow), or
• what you receive (to save and lend).

Higher interest rates tend to attract capital seeking to earn the highest returns on their savings and lending. With this, investors have to assess whether the interest rate earned is commensurate with the inflation risk they would assume, assuming other key factors are unchanged.

Foreign exchange rates, interest rates and inflation tend to all move in the same direction (all rise or decrease together). For example, rising inflation levels tend to pressure central banks to raise interest rates; this should also heighten both currency demand and exchange rates.

You can see the strong correlation between North American Central banks overnight lending rates decisions on the chart below.

Trading activity

A country’s imports and exports of goods and services will have a definite impact on the value of their local currency. A country that exports more (sells more of their goods and services to another country) than they import (spends more of its currency bringing in foreign goods and services) will tend to see their currency appreciate in value. Alternatively, when a country’s imports exceed their exports, they generally experience currency depreciation as larger amounts of the local currency is needed to purchase foreign goods and services.

The trade relationship between Canada and the US has historically been a material factor driving the Canadian and US dollar exchange rate. Canada is the third largest exporter of oil in the world and the USA is one of the largest importers of Canadian crude oil. When the price of oil is high, Canada receives more US dollars and the supply of US dollars coming into Canada is higher, typically appreciating the Canadian dollar.

How do these factors pertain to a Canadian investor with USD exposure?

I’m sure as you read this article you noticed a theme developing for the US and Canadian Dollar exchange rate: key factors associated with currency valuations have common exposure across North America. Inflation rates and interest rate policies are generally consistent between Central Banks, in addition to trading activities such as Canadian oil exports to the US.

For these reasons, across long-time horizons, USD/CAD has mean-reverting tendencies. Mean-reversion describes that over a long-time horizon a given exchange rate should move towards average levels. For example, a recent surge of USD appreciation (or CAD depreciation) should rebalance back to average levels as key factors resume historically normal levels. This is why many Canadian institutional investment managers hedge USD exposure, so they can avoid having their investment returns being materially impacted by swings in USD exposure largely out of their control, when in the long-run they anticipate the exchange rate to revert back to an average level.

So what does this mean for the average Canadian investor? In part I of this currency risk series, we discussed how investing internationally in a well-diversified portfolio with long-term investment strategy acts as a “natural hedge”; where the impact of foreign currency fluctuations will generally lessen and offset one another.

The reality is, if you are investing and spending in Canadian Dollars, your currency exposure is not likely something that needs to be actively managed, but it’s still insightful to understand the key factors that contribute to currency movement. If you maintain a well-diversified portfolio under a prudent long-term investment strategy and let your skillful investment managers assess whether or not they need to hedge their currency exposure, you will be well-positioned to meet your investment goals.