Currency markets acting irrationally can mean opportunities

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There is something very strange going on in global currency markets that has us stumped, but it could provide some hidden investing opportunities should there be a return to rational thinking.

Currency and bond markets are generally quite efficient over the longer term, but this doesn’t mean they can’t act irrationally in the near term, such as the recent strong sell-off in the United States dollar against major world currencies.

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Interest rate parity dictates that the currency of those countries with the greater potential for rate cuts should depreciate. The reason for rate cuts is twofold: to deal with falling inflation and weakening economies. Those with weaker economic outlooks have to cut at a faster pace than those with a stronger economy.

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However, the exact opposite is happening, as jurisdictions such as the European Union and Canada have a softer outlook than the U.S. and yet their currencies are doing much better recently.

The real gross domestic product (GDP) growth rate for Canada in 2024 is expected to be 1.2 per cent compared to 2.7 per cent in the U.S., according to the International Monetary Fund. Most of Europe is well under one per cent, with the United Kingdom expected to come in at 0.5 per cent, Germany at 0.2 per cent and France at 0.7 per cent.

That said, the U.S. dollar index (DXY) has been selling off, losing more than 4.5 per cent in the past 12 months and down a whopping 11 per cent from its September 2022 highs. More specifically, the U.S. dollar has fallen five per cent against the euro over the past 12 months and is flat against the Canadian dollar.

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Therefore, currency markets are implying that the pace of rate cuts in the U.S. will match those of Canada and possibly exceed those in the E.U. despite that country having a much stronger economy. How does this make any sense?

Meanwhile, U.S. investors have been rewarding interest rate-sensitive sectors more so than in other countries on this trade. For example, look at the utilities sector in Canada and the U.S. as represented by the iShares S&P/TSX Capped Utilities Index ETF and Utilities Select Sector SPDR Fund. Over the past 12 months, the former has gained nearly 15 per cent, but that is half of the latter’s 30 per cent gain.

Then there is the oil market. Oil has a long-term inverse correlation with the U.S. dollar. This makes sense because oil is paid for in U.S. dollars and so each move in the dollar or the price of the commodity generates “a realignment between the greenback and numerous forex crosses.”

However, this relationship has changed. The two have since been moving together as West Texas Intermediate near-month oil is down more than 24 per cent over the past 12 months while the DXY dollar index is down five per cent.

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Perhaps this is because countries such as the U.S. have been turning a blind eye to Iranian- and Russian-sanctioned barrels being sold on the market in other currencies? Perhaps it’s driven by the intent of the U.S. government to reduce oil and gasoline prices ahead of the election?

We really don’t know, other than there being a lot of “perhaps” scenarios playing out, but one thing is certain: eventually, the longer-term historical relationship will return. This means that either oil or the U.S. dollar are undervalued.

We are leaning towards the latter, which also means that the Canadian dollar is overvalued, not only because of lower oil prices, but because of the widening divergence between our two economies.

Based on our worsening real per-capita GDP figures, we think Canada is close to being in a recession that is being masked by our record-setting immigration levels. I also just read an estimate that Justin Trudeau’s recent capital gains inclusion rate increase will reduce Canada’s GDP by $90 billion, real per-capita GDP by three per cent, its capital stock by $127 billion and employment by 414,000. These are not small numbers.

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All this will eventually play catch-up, resulting in larger and more accelerated rate cuts and a weaker Canadian dollar. Today’s current situation could provide an opportunity to hedge this risk by owning more U.S. dollars. You could also own some Canadian oil companies that will benefit from their revenue streams being in U.S. dollars while their cost base is in Canadian dollars.

Martin Pelletier, CFA, is a senior portfolio manager at Wellington-Altus Private Counsel Inc., operating as TriVest Wealth Counsel, a private client and institutional investment firm specializing in discretionary risk-managed portfolios, investment audit/oversight and advanced tax, estate and wealth planning. The opinions expressed are not necessarily those of Wellington-Altus.

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