Time to hedge U.S. currency exposure

The Canadian dollar has been rising steadily against the U.S. dollar recently, due in part to increasing demand for commodities, and in part to the sagging greenback.

Global uncertainty toward the U.S. dollar was bolstered on Wednesday, as Sergei Shvetsov, head of open market operations for Russia’s central bank told his government that the bank was preparing to convert some of its foreign currency reserves into Canadian dollars.

Russia holds the world’s third largest gold and foreign exchange reserves, worth about US$441.7 billion. The announcement gave the loonie a temporary pop this morning, rising half a cent overseas before moving lower.

“We’ve seen central banks around the globe look at their largely U.S. dollar foreign reserves and not be comfortable with that,” says Stephen Lingard, co-lead manager of Franklin Templeton’s Quotential program. “Central banks are holding too many U.S. dollars and they all want to move to more diversified foreign exchange holdings.”

This diversification strategy is similar to that of an investment portfolio, he says. It’s simply prudent to hold multiple non-correlated assets.

“I think for a long time there was a lot of complacency around the U.S. dollar as being the world’s currency, and that’s just the way it was,” he says. “You can see that they don’t always have the best interests of international investors in mind.”

Lingard admits that the Russian announcement is the first time he’s heard a foreign central bank specifically mention the Canadian dollar as a reserve currency. But he says that it makes sense, given the secular trend in commodities, the prices of which have a direct impact on the loonie.

But the close trading relationship between Canada and the U.S. means that the loonie is also influenced by American economic performance.

“We can only decouple so far, when 75% of our trade is tied to that large partner,” Lingard says, pointing out that there many Asian currencies are far less reliant on the U.S. economy. “The big difference that I see is the current and ongoing demand for our resources.”

Shvetsov told the Russian Duma that the central bank may also diversify into “one or two” other currencies, according to a report from Bloomberg. India and Brazil have been floated as possible options.

Lingard suggests that central bankers are facing a similar conundrum as asset managers when looking at emerging markets. Both the currency and the capital markets of emerging markets have historically been far more volatile than those of the developed world. But some emerging markets have become quite stable.

“There are a couple of strategists who say that the Royal Bank of India is one of the best globally managed central banks,” he says. “If we’ve moved to a market where central banks are judged on their ability to manage their capital markets, and allow their currency to adjust to fundamentals, I think an argument can be made for less volatility in the currency market down the road.”

The best bet for investors is to at least partially hedge their exposure to the U.S. dollar, as this is now an uncompensated risk.

“Generally speaking, any of the U.S. assets that we have, on the fixed income side, are hedged back to Canadian dollars just as a matter of course. That’s not a tactical view,” he says. “On the equity side…it probably makes sense to hedge the U.S. dollar exposure at least partially as well. One of our big holdings, I’d say 30 to 40% of our overall U.S. equity exposure, is hedged back to Canadian dollars.”

(11/25/09)