Why the loonie's future looks gloomy

Fluctuations in the loonie's value not only affect the cost of travel, but they also have important implications for investors' portfolios; diversifying in advance of a currency's decline can be very rewarding.

Put simply, it's tough to be optimistic on our dollar, especially its exchange rate with its U.S. counterpart. For this reason, investors should give serious thought to protecting themselves against the possibility that, despite recent strength, the Canadian currency may weaken considerably in the years ahead.

Monetary policy

Arguably the most important reason to be bearish on the dollar is the divergence in monetary policy between the Bank of Canada and the U.S. Federal Reserve. As it stands, the Fed is on a path to raise short-term interest rates, having hiked in December. On the flip side, Bank of Canada Governor Stephen Poloz recently stated that a possible rate cut is still on the table, pointing to risks for Canada from the Trump administration's economic policies. Higher U.S. rates, coupled with reduced Canadian rates, will tend to draw investors into the American currency at the expense of our dollar.

It's worth considering that in the years to come, this chasm between the Fed and the Bank of Canada could become even more pronounced. Indeed, many analysts now believe that Canada has a housing bubble. Real estate in Canada is, by some measures, a more overvalued market than what the U.S. experienced at the peak of its housing mania. Even without a bursting of the housing bubble, the Bank of Canada's policy rate stands at a paltry 0.50%. What would happen if the bubble burst, sending the economy into a tailspin?

It stands to reason that the Bank would respond aggressively, just as the Fed did in 2008. First, it would slash its interest rate even further, assuming it hadn't done so already. And given the economic hit the country would likely face, it's also probable that the central bank would decide to go even further. Indeed, the Bank of Canada publicly admitted in December 2015 that it is studying what it would do if the country was hit by an economic shock, given that rates are near zero.

One option in the Bank of Canada's toolkit, which many central banks around the world have already enacted, is what's known as quantitative easing, or QE, where the central bank creates new money to buy assets such as bonds. The specific aims of this manoeuvre can vary, but all are intended to aid the broader economy.

If the U.S. central bank is raising rates at a time when the Bank of Canada is pursuing a policy of QE, that should result in the greenback appreciating, perhaps by a lot, against the loonie.

Commodity prices

Of course, monetary policy is not the only determinant of a currency's value. In the case of Canada -- a large producer and exporter of energy, metals and grains -- commodity prices also play a large role. Changes in the value of these resources typically have a direct effect on the Canadian dollar. When commodity prices are rising, the loonie tends to rise against the U.S. dollar and vice versa.

What, then, are the medium- to long-term prospects for commodity prices?

Again, there's reason to be cautious. Take oil, for example. At nearly US$54 a barrel, oil prices have doubled from their early 2016 lows. But given the price rise, previously unprofitable U.S. shale production is likely to come back on line. This added supply may not in itself cause another crude crash, but it should restrain prices. On the demand side, an economic hard landing in China, which many see as a distinct possibility, would likely be quite bearish for oil.

To hedge or not to hedge currency risk?

This is a pertinent conundrum for Canadian investors. Morningstar looked at the merits and drawbacks of insulating oneself from foreign currency volatility in this video. As Michael Keaveney, head of investment management at Morningstar Canada, noted in the clip, research on currency movements makes a reasonably strong case against Canadian equity investors hedging their U.S. dollar exposure because there is a negative correlation between the direction of U.S. equity stock prices and the value of the U.S. dollar versus the Canadian dollar. In other words, when the U.S. market goes down, the U.S. dollar usually goes up against the loonie, making up for some of the losses.

That said, there are many funds that offer exposure to foreign securities, but with the currency risk hedged out, providing you with exposure to the underlying securities but not to the fluctuations of the currency they are denominated in. For instance, if you invest in a currency-hedged ETF that tracks the S&P 500 Index and the U.S. dollar falls, that does not cut into your return. Examples of currency-hedged funds that trade on the TSX include:

• iShares Core S&P 500 Index ETF (CAD-Hedged) (XSP)
• BMO NASDAQ 100 Equity Hedged to CAD Index ETF (ZQQ)
• Horizons 7-10 Year Treasury Bond CAD Hedged ETF (HTH)

On the other side of the coin, investors can buy ETFs that track U.S. equities and do not hedge the currency. An investor who wishes to have exposure to both markets and the U.S. dollar may want to consider these ETFs that trade on the TSX:

•  iShares S&P 500 Index ETF (XUS)
•  Vanguard U.S. Total Market ETF (VUN)
• BMO Mid-Term U.S. Investment Grade Corporate Bond ETF (ZIC.U)

Mind you, investors looking for currency diversification can do so outside of the equity market. Opening a U.S.-dollar bank account or purchasing a U.S.-dollar denominated ETF are two easy ways to achieve the same goal.