Why You Should Consider Increasing Your FX Hedges
Into 2025, one of the more pressing questions for Canadian investors is whether or not to hedge FX exposure to U.S. assets from here.
Yes, we understand that this might sound crazy. Not least as it’s almost inevitable now that Trump will immediately levy 25% tariffs against all Canadian exports once he’s inaugurated on January 20. However, our contention isn’t that Trump is going to have a change of heart – it’s that the market is likely pricing this in as a near certainty already. That has meaningful implications for portfolios going forward.
Why do we get the sense that the market has already fleshed out this theme? Well, one can get an idea by looking at proxies of positioning in the FX space – namely in the futures market.
Recall, that getting an accurate feel for positioning in an over-the-counter (OTC) market like FX is notoriously difficult because of its sheer size, and the lack of frequent, centralized data. The best we have is a triennial survey conducted by the Bank for International Settlements (or BIS), but this data is compiled and released every three years. Data from some brokers and settlement service providers can be helpful, but is also released with a lag of a few months. That means there’s little practical use for them when it comes to investing decisions.
Nevertheless, there’s good reason to suspect that trends in currency positions tend to correlate between different instruments. What’s more is that we can get a sense of the scale of positioning as well. For instance, if positioning in the futures market suggests that net non-commercial investors (or those that are speculating on currency movements using futures) have built up the largest short Canadian dollar (CAD) position in years, then there’s a good chance that speculators are using larger and more liquid FX instruments (spot, options), as well.
We bring this up because there is a massive net short position that has been built up in the CAD futures market (see Chart 1). This is an important contrarian indicator – rough empirical analysis shows that when positions get large enough, we tend to see a corresponding shift the other way in the underlying currency.
Chart 1 – Net Speculative CAD Positions Close to Extremes
To demonstrate how positioning can be predictive, take Chart 2, which shows the one-, two-, and three-month performance for the U.S. dollar (USD)/Canadian dollar (CAD) after net short CAD positioning in the futures market has reached sizeable levels. To determine what ‘sizeable’ means, we standardize the overall level of positions and use a -1 standard deviation1 as the ‘trigger’ for when we feel that short CAD positioning has become large enough. From Chart 2, we see that USD/CAD has averaged a gain of 0.50% one month after the trigger has been reached over the past 10 years. That return increases to 1.02% two months later and 1.58% three months later.
Chart 2 – Average CAD Return (Against USD) Once Net Shorts Breach Trigger
The current standardized score for positions is -1.2, which tells us that the risks are now skewed towards CAD gains in the coming months. One way to conceptualize this qualitatively is to ask - with a lot of bad news in the price, where is the marginal net short position going to come from?
Indeed, when short positions become this large, it becomes important for investors to consider alternatives. In this case, Canadian investors should look at increasing hedges to protect against risks that the CAD could rally from here. To us, there are two potential sources of ‘surprise’ that could lead investors to exit short CAD positions:
- Canada secures some form of carve-out from tariffs
- The Bank of Canada (BoC) doesn’t cut by as much as the markets expect
The latter is more likely than the former – primarily because monetary policy conditions are ‘passively easing’ already via a weaker CAD. At the margin, that obviates the need for the BoC to ease by as much going further.
In any case, it makes sense for investors to be proactive when it comes to managing their FX exposures from here. Currency markets are both notoriously fickle and extremely unforgiving to those that don’t manage them.
For broad market exposure to U.S. equities, we would recommend the BMO S&P 500 Hedged to CAD Index ETF (Ticker: ZUE). Investors looking for a slightly more defensive posture through a quality screen can consider the BMO MSCI USA High Quality Index ETF - Hedged Units (Ticker: ZUQ.F). Finally, for more cautious investors, the BMO US Equity Buffer Hedged to CAD ETF - January (Ticker: ZJAN) uses ZUE as its underlying reference index, allowing holders to participate in additional U.S. market upside, while providing a “buffer” against downside performance while hedging their currency risk.
Performance (%)
Year-to-Date |
1-Month |
3-Month |
6-Month |
1-Year |
3-Year |
5-Year |
10-Year |
Since Inception |
|
23.44 |
-2.58 |
1.99 |
7.54 |
23.44 |
7.30 |
12.73 |
11.50 |
13.29 |
|
22.18 |
-3.34 |
-1.04 |
3.30 |
22.18 |
7.59 |
- |
- |
14.31 |
|
Returns are not available as there is less than one year’s performance data. |
|||||||||
As of December 31, 2024. Inception dates for ZUE = May 29, 2009, ZUQ.F = July 17, 2020, and ZJAN = January 24, 2024.
1 Standard Deviation: A measure of risk in terms of the volatility of returns. It represents the historical level of volatility in returns over set periods. A lower standard deviation means the returns have historically been less volatile and vice-versa. Historical volatility may not be indicative of future volatility.
Volatility: Measures how much the price of a security, derivative, or index fluctuates. The most commonly used measure of volatility when it comes to investment funds is standard deviation.
BMO Buffer ETFs seeks to provide income and appreciation that match the return of a Reference Index up to a cap (before fees, expenses and taxes), while providing a buffer against the first 15% (before fees, expenses and taxes) of a decrease in the Reference Index over a period of approximately one year, starting from the first business day of the stated outcome period.
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Changes in rates of exchange may also reduce the value of your investment.
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January 15, 2025