Currency volatility: Diversifying can payoff, but requires sound risk management

On Aug. 5, when most Canadian we’re hitting the snooze button on the start of another week, global markets were waking up to a very different reality. The Bank of Japan’s most recent interest rate hike, prompted by uniquely domestic economic conditions, exacerbated its divergence from the policy posture of most other developed market central banks. A weak U.S. jobs report in the days that followed further reinforced this divergence, on increased expectations of a U.S. Federal Reserve interest rate cut in September. The resulting yen appreciation, and subsequent unwinding of yen-funded carry trades, contributed to a wave of events that caused violent swings in global currency (and equity) markets.

For international businesses, such volatility can translate into real-world headaches, such as weaker global demand, uncompetitive pricing, rising input costs, and compressed margins. For Canadian exporters, in particular, monitoring the USD-CAD exchange rate is vital, with almost 80% of our exports destined for the United States.

In the post-pandemic period, the U.S. dollar has strengthened by more than 10% against a basket of currencies (including the loonie), driven by its role as the world’s leading haven currency. The remarkable resilience of the U.S. economy over this time has added to its appeal, and buoyed demand for U.S. dollar assets. The Fed’s higher-for-longer policy stance further increased the attractiveness of U.S. dollar returns this year, especially when compared to moves by other central banks (including the Bank of Canada) to begin cutting interest rates.

Historical data suggest that, all else equal, each one percentage point of rate cuts in excess of the Fed, drives a corresponding 4% change in the value of the Canadian dollar. While the weaker Canadian dollar and a strong U.S. economy creates a more favourable export environment, it also translates into higher import costs for Canadians.

For the time being, and even if the Fed cuts rates by 25 basis points in September, the Bank of Canada’s head start should keep downward pressure on the Canadian dollar, relative to the greenback. As the Fed’s rate-cut cycle takes hold, however, that pressure should begin to ease. But, the upcoming U.S. presidential election could help bolster the U.S. dollar, as we saw in both 2017 and 2021, and any significant geopolitical or economic risk events would cause investor flight to quality, further strengthening the U.S. dollar.

For Canadian exporters looking to expand into non-traditional markets, currency volatility can further heighten the risk of doing business in developing markets. Elevated U.S. interest rates and the strong dollar have introduced significant challenges to developing market growth and financial conditions. Local currency weakness impacts not only the domestic economic and business environment, but also hard currency transfer and exchange risks. The most fragile markets could experience large-scale currency depreciation, or plummeting foreign exchange reserves, leading to restrictions on currency conversions.

In response, some developing market central banks will choose to support local currencies by reducing rate cuts (Brazil), pausing rates (Mexico), and even hiking rates (Indonesia). While such strategies can help limit the pressure on local currencies, they will often weigh on domestic demand. Expected Fed rate cuts later this year should reduce the burden on many of these countries, giving them room to ease monetary policies and nurture economic activity.

So, how can Canadian exporters better prepare for currency volatility? First, diversification is key. Expanding into multiple markets helps reduce reliance on a single currency or economy. If an exporter trades primarily with the U.S., exploring opportunities in the Euro Area or the Indo-Pacific region can help mitigate the impacts of sudden currency shifts. 

Exploring a variety of hedging strategy options can also provide additional security. Financial instruments, like currency swaps, forward contracts, futures, and options can help lock in exchange rates and protect your business against unforeseen fluctuations. And, finally, building strong, in-market relationships is absolutely critical. Local partners can offer valuable on-the-ground insights, and specialized financial institutions can help you structure flexible business strategies and robust financial solutions.

The bottom line?

Managing currency volatility is the price to pay for growing your international footprint. But staying informed on currency outlooks and being prepared for possible volatility can help Canadian exporters manage risks. By diversifying portfolios, monitoring economic and political developments, employing effective hedging strategies, and building strong partnerships, exporters can mitigate risks and maintain their competitive edge in the ever-changing global trade landscape.

This week, special thanks to Juntian Li, quantitative analyst in our Economics department.

As always, at EDC Economics, we value your feedback. If you have ideas for topics that you’d like us to explore, please email us at economics@edc.ca and we’ll do our best to cover them.