Every once and a while I pick up on a fad and adhere to it with stubborn conviction. This last week I’ve been having fun controlling everything that Darcy eats. He came around to it slowly, trying to bargain for his preferred palate, but eventually submitted. The Meagan Diet really wasn’t as bad as it sounds. No processed foods, nothing with added sugar, no alcohol or caffeine, and, to quote Leo Babauta from Zen Habits, “a crapton of veggies”.
Okay, well I guess it does sound kind of bad.
But Darcy stuck with it for a whole week, and by the end of the week it had become his new normal.
It’s amazing how quickly people can accept extreme circumstances as normal. Whether it’s positive, like a diet fueled by veggies, or something more ominous, like low interest rates, household debt-loading, or beyond-justified housing prices, we can be really good at adapting and accepting. Maybe a bit too good some times.
One of the things that Canadians have become accustomed to is a near-par dollar. After being below-par for just about four decades, the Canadian Dollar spent most of 2008, 2011 and 2012 above par with the U.S., the surrounding years trailing mildly.
Then in 2013 the Canadian dollar started to fall. And it’s been on the slide ever since.
Now the leaves are beginning to change color, students are returning to school, and snowbirds are quietly preparing for their annual pilgrimage to warmer climate. As soon as it’s time to go get some money transferred to their American bank account, some snowbirds are going to be in for quite a shock. This time last year one Canadian dollar could buy you about $0.92 American. As of today we’re just above $0.75.
When change is welcome, we accept it quickly – part of a cognitive bias called framing. When change is less welcome, we resist it, clinging to the past with disbelief and offense. The Canadian dollar has come down significantly in a relatively short period of time. Resistance is strong.
Let’s break down the current state of the dollar and where we’re likely to be going forward.
First, the Canadian dollar is really low because we’re in a recession. The Bank of Canada’s typical response during a recession is to lower interest rates in an effort to spur spending and investment. A side result is that investing in Canadian interest-bearing products is less enticing to foreign investors, and so with lack of demand for the dollar, the price (as comparable to other currencies) falls.
This is actually a healthy side effect for a recessed exporter country. Especially for a country like Canada, where we’re good at selling stuff (oil, grain, beef, manufacturing) and snuggled right next to a country like the States, who love to buy stuff. When our dollar is low, the Americans can afford to buy more of our stuff for less of their dollars, which is good for both sides.
Second item: The American dollar is also low right now due to low interest rates, as stubbornly lingering symptom of battling the last recession.
A large extent of what happens next will depend on who increases their interest rates first. If we increase our rates first, the Canadian dollar is likely to move a bit closer to par with the US. If the Americans increase their rates first, the Canadian dollar is likely to sink further away from par with the US.
And so how likely is either scenario? On the American side, job growth appears strong, and analysts are suggesting a possible interest rate hike as early as September 2015. On the Canadian side, housing starts are in decline, job growth is stagnant if not negative, and our yield curve is brutally flat. Analysts are suggesting further potential interest rate cuts may be in our future. Therefore, the chance that the Americans raise their interest rates before we do is quite strong.
But what about a natural reversion to the mean? What goes down must come up, right?
For this we look to the Big Mac index – a currency index published by the Economist that compares the cost of a literal Big Mac around the world to GDP per person. The Big Mac Index published in July 2015 suggests that at $5.85 USD for an average Big Mac in Canada, our currency is only 5.3% undervalued. During the previous peaks in 2008, 2011 and 2012, we were as much as 25% over-valued. Therefore, while the potential for reversion to the mean is pretty high, it’s only worth around 5% - which would put our dollar right around $0.82 USD.
In summary, at least over the near term, there is significant risk that the Americans raise their interest rates before we do, which is likely to result in further suppression of the Canadian dollar. In addition, regardless of recent near-par history, the Canadian dollar really isn’t that far off where it should be.
So how can you protect yourself from these currency struggles?
The first thing to do is to watch your home bias. A natural home bias (investment in Canada) should be worth no more than 20% to 30% of your portfolio, not counting GICs. Anything above 30% and you’re potentially facing serious concentration risks. By investing the bulk of your portfolio outside of Canada, pressures as home causing our dollar to sink create a defensive rise in the relative value of foreign-denominated holdings, which can make recessions a lot easier to bear.
The second thing to do is review your plan and watch out for your cash-flow goals. If you’ve set a travel budget of $10,000 Canadian, your travel goals could look quite a bit different from any previous near-par years. If you feel like you need to spend more to retain the same standard of living you experienced before, then make sure it’s sustainable in your financial plan first. Otherwise, consider travel within Canada this year.
If you have questions on how to use defensive structuring to protect your portfolio from currency swings, or for more information on planning for a sustainable income during financial independence, speak with a Certified Financial Planner today.
Written by Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER®
Advantage Insurance & Investment Advisors
Investment Funds Representative
Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.