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The currency market is the largest financial market in the world. It turns over trillions and trillions of dollars every day. But what exactly is it? This episode is all about making sense of the currency market, also known as the foreign exchange market or FX for short. Our guest, Shaun Osbourne, Managing Director and Chief Currency Strategist at Scotiabank explains what makes these markets go up and down, what role the exchange rate has when it comes to inflation, where the Canadian dollar might be headed and much more.
Key moments this episode:
1:33 — Why do currencies go up and down?
2:28 — Why the currency market is the “purest form of the market”
3:19 — How do investors or institutions use the currency market?
6:23 — A quick history lesson about the gold standard
7:39 — Why is the U.S. dollar the currency in which others are judged?
10:13 — Why wouldn’t countries like Canada just use the U.S. dollar as its currency?
11:59 — Decoding the currency ticker
12:40 — Breaking down why the Canadian dollar dropped in the past year
14:27 — Who benefits when the Canadian dollar is low? Who likes it when it’s high?
16:19 — Ballparking a ‘Goldilocks’ rate for the Canadian dollar
16:36 — Where might the Canadian dollar go in the next six months?
Transcript:
Stephen Meurice: So what exactly is the currency market? There’s a good chance you’ve had firsthand experience with it last time you traveled abroad.
Shaun Osbourne: If you're going to you going on vacation, you might need some US dollars to spend in Disneyland. If you go to Europe, you're going to need some euros.
SM: That’s our guest today, Shaun Osbourne.
SO: At a very basic level. It's where counterparties, that means buyers and sellers come together to exchange currencies.
SM: Simple enough, right? You need some money to go ride the spinning teacups, or whatever they call the spinning teacups at Euro Disney, you go to the bank and change your money over maybe you shop around a bit or wait for a good rate. That’s kinda what Shaun does, but at a much larger scale.
SO: The currency market turns over trillions and trillions of dollars every day. It's the largest financial market in the world.
SM: Shaun is the Managing Director and Chief Currency Strategist at Scotiabank. His job is to keep close tabs on all these fluctuating rates, because his clients, they’re not trying to go to Disneyland, I don’t know, maybe they are, but he works with investors and businesses. And these markets could have a huge effect on their bottom line. Shaun’s here today to give us a primer on the currency market. Also known as the foreign exchange market or FOREX or FX. Wow, it’s already complicated. Lucky for us, he’ll explain in plain language what makes these markets go up and down, help us understand what role the exchange rate has when it comes to inflation, even give us a bit of insight on where the Canadian dollar might be headed and much more. I’m Stephen Meurice and this is Perspectives.
Shaun, thanks so much for joining us today.
SO: My pleasure.
SM: All right. Let's jump right into it. Why do currencies fluctuate? I don't know if that's a simple question or a really complicated one. What causes them to go up and down?
SO: Many different rabbit holes we can go down there. A good starting point is to view currencies like you would any other financial asset, and they fluctuate along with the underlying fundamentals. Good fundamentals typically mean a currency will appreciate. Bad fundamentals, that might mean high unemployment, slow growth, government instability, market uncertainty, a general lack of confidence in the policies prevailing in the country at the time, those kind of things can all contribute to pushing a currency lower. So those kind of things, over time, they can ebb and flow, they applied differently to different currencies at different points in time. It's very hard to pin down a sort of set list of criteria that we can sort of run through to define what means a currency. But they're essentially the core drivers.
SM: So, I guess you're watching these markets throughout the day, you're tuned into the fluctuations happening. Let’s say there’s something like a government announcement about some kind of economic policy in the news, do you see an immediate impact when you're looking at the ticker?
SO: I think a lot of people, myself included, view the currency market is probably the purest form of a market where almost instantly new news and new factors are priced into the price at any given point in time. The market opens essentially early Monday morning in Asia and rolls right through 24 hours a day until 5:00 on a Friday afternoon in North America. And any given point in time, that's to say, potentially out of office hours in North America, you can have some piece of news that emerges that can affect the Canadian dollar or the U.S. dollar. And you come in the mornings and you have to factor that new development into your thinking. But inevitably new news as it happens, is priced into currencies very efficiently and very effectively. It's a very efficient market. It turns over trillions and trillions of dollars every day. It's the largest financial market in the world.
SM: Wow. This is probably another much more complicated question that I really want to ask, but I will anyway.
SO: [laughs]
SM: How do investors or institutions or people like you use currency? What do you do with it? What is it that you do? You hear about using it as a hedge? And so what is it that you do when you're handling these multimillion-dollar currency transactions?
SO: It's very basically, like I said earlier, you know, the currencies can be viewed as another investment vehicle. It wasn't that long ago that I think investors generally tended to ignore the exchange rate as a factor. If you were a Canadian investor looking at equities, you probably had a portfolio of equities. Some of that might be U.S. dollar denominated. People didn't really consider the exchange rate as a factor. Now we get to a point in the early 2000s where we saw a significant weakening in the Canadian dollar. And lo and behold, those investors that were looking at their investment returns in the U.S. and trying to figure out one of their investment returns was so low it was because they hadn't hedged the currency risk. So now we are in an environment, an era, where a little bit less so these days, but some investors view the currency as an additional part of the investment process. So for example, you would buy a portfolio of U.S. equities and you will try and manage the exchange rate to either enhance returns or reduce the volatility in that portfolio. And that's an important part of the work that we do with our institutional clients who are typically running very significant portfolios of investments that have some U.S. dollar denominated assets. And they are trying to manage the currency risk revolved around which it basically entails hedging or selling the U.S. dollars to try and mitigate the exchange rate risk in that portfolios. Our job is to try and advise when it's opportunistic to do so, what products that should be used to try and hedge that risk. And for our exporter base, it's a similar challenge, slightly different in the approach I guess. But many of our clients are exporters to the U.S. They have U.S. dollar receivables, but they have Canadian bills that have to be paid, they have payroll to make. So they want to convert those U.S. dollars at the most optimal rate for them. So again, the role is to try to advise appropriate tactics, strategies to convert that risk or hedge that risk on a short or multi-month, multi-quarter basis.
SM: So if I understand then, it is about whether it's for the investors or the exporters, who have a certain amount of their holding currency, say U.S. dollars, and then just trying to decide what's the best point to convert it into some other form of currency…
SO: To convert it back to Canadian dollars, essentially. Now, the added wrinkle there is that what you do might be good for you at one level, but your competitor might be doing something else and hedging at a different rate that gives him or her a slightly better pricing advantage. So it's not a straightforward buy here, sell there kind of equation, there's a lot of a lot of different variables that go into this. I think investors or other corporate and commercial clients will become more comfortable with over the last couple of decades. It's become much more common, clearly, and the ability to use different products to hedge that risk has provided a lot more opportunity, flexibility to try and mitigate some of those risks.
SM: Okay. Can we step back, do maybe a little bit of a history lesson? It used to be that currencies were under the gold standard, they were pegged to gold.
SO: Right.
SM: Can you explain what that meant and why it changed?
SO: Probably not very well, because I'm not an economic historian.
SM: [laughs]
SO: But essentially the concept is that currencies were fixed to gold and that was the key policy of economies. The gold standard was the driver or the key lever for financial policy. I guess in the early part of the 20th century, late 19th century, it's very common for countries to be on a gold standard. Most countries were in fact operating on a gold standard. It kind of comes around, I think every now and again, particularly at the moment, I guess when we’re talking about inflation, there's often talk about maybe we need to revert to a gold standard to help try and control inflation. I don't think that's particularly a good idea I think there's a degree of sort of look at the gold standard through rose tinted glasses, I think to some extent. It's not the panacea to some of the problems that we're seeing these days, that maybe some people think it is. Historically, it hasn't been able to dampen volatility and growth and inflation in the way that I think people think it might. So the very little I know about the gold standard tells me that it was a system that worked in a certain era, under certain circumstances. I don't think it's at all appropriate for the modern economic era that we're experiencing right now.
SM: Okay. And right now, what we have is a U.S. currency, the greenback, as they call it, that is sort of the currency against which others are judged. Often, I guess, considered a safe haven currency. How did that come about? Is that simply because it's the biggest economy in the world and therefore the one everybody compares themselves to?
SO: Yeah, I mean, essentially that. That in and of itself is another illustration perhaps of how foreign exchange and currency markets have evolved over time. The U.S. dollar is the kind of 800-pound gorilla of foreign exchange markets these days because the U.S. economy is the largest economy, effectively, in the world. We look around at commodities, large capital goods, ships and aircraft all priced in U.S. dollars, commodities priced in U.S. dollars. The U.S. dollar is deeply, deeply embedded in the global financial system. When you look back in history, it might have been the pound sterling prior to or around about the First World War, in the First World War period when the British Empire was the largest kind of economic trading bloc in the world. And going back even further in history, and you look at all these other countries or empires that have had influence at a certain point in time, it was typically their currencies that were the dominant measure of trade, historically. So the dollar is the de facto benchmark currency on the trading floor. When we're looking at currencies, we typically look at currencies in terms of their value against the U.S. dollar. And it's a situation I think that's probably going to continue. As I said, the dollar is deeply, deeply embedded in the global financial system. There are currencies coming along that potentially could rival the U.S. dollar, but the potential for them to overtake the U.S. dollar in a timeframe that's relevant to us in this discussion I think is pretty limited.
SM: Right. Even as economies grow, I guess arguably China competing with the United States as some potentially the biggest economy in the world.
SO: It certainly could, yeah.
SM: But it's just their currency is not embedded in the global system in the same way.
SO: And not a fully floating, freely exchanged currency in the way that the U.S. dollar is. It's still restricted. So that's a big strike against any currency that has ambitions to be any sort of global benchmark currency. Obviously, the euro is emerging as a potential rival to the U.S. dollar. The economy is similarly sized to the U.S., but the euro is still a relatively young currency. We only have a roughly 20 years of experience of this. It's easy to forget that the euro hasn't really been around for that long. It's still a relatively new and to some degree experimental currency, so that has the potential to rival the U.S. dollar. I can see a situation maybe in the future where we go to instead of a single currency dominating, we go to a bipolar or tri polar world where we have two or three different currencies that are vying for that top spot over time. But it's very hard, I think, from my point of view at the moment, to see the U.S. dollar being replaced as this global medium of transaction, this global benchmark that we have today.
SM: So if the U.S. dollar is so deeply embedded in the economies of all of the world and so many transactions, why wouldn't countries just use the U.S. dollar as their currency?
SO: So that's an interesting question. It does come up every now and again. And some countries, some smaller economies have effectively dollarized. They've given up their own domestic currency and gone to a U.S. dollar-based system. That can work for some smaller countries. It was, I do remember very early in my days in Canada, late 1990s, early 2000, when the Canadian dollar was under tremendous pressure at the time. We got down to, I think, a low point of $0.60, $0.62 against the U.S. at that point. There was a suggestion, I think, from some people that, you know, maybe moving to a U.S. dollar could be an answer to the challenges that we were facing in Canada at the time. I think that was completely wrong. And subsequently we saw the Canadian dollar recover and we quickly moved on from that period. But essentially what you're giving up is a seat at the table. In terms of policy making, in terms of the ability to adjust to domestic challenges and shocks. If we were, for example, the dollarize here in Canada, there would be no doubt the Federal Reserve would, for example, continue to set policy with the best interests of the U.S. in mind and probably take very little in consideration of events and developments in Canada. So, you're giving up a lot in terms of your ability to control your own destiny from a policy point of view, from a currency point of view. And we've come to learn, I think, in Canada that a fluctuating exchange rate. as the Bank of Canada often says, is something of a shock absorber. In times of economic weakness, the currency typically depreciates, and that can give us a bit of a cushion against some of these economic headwinds. Equally, in times of very strong economic growth, when inflationary pressures are typically higher, the exchange rate has tended to appreciate and does a bit of the heavy lifting for the bank teller in terms of trying to curb some of the excesses in the economy and weigh down on those inflationary pressures.
SM: Right. Just looking at the ticker showing the value of the dollar, right now it's around 0.73443. That means it's worth 73.433 cents U.S., roughly.
SO: Correct.
SM: Just as an aside, why are there so many decimal points? Is it because there's so much money traded that need like such really small fluctuations are going to make a difference to investors or governments or…
SO: Essentially, correct. I mean, it's because you're essentially trading in large amounts of money, typically on a wholesale trading floor and you're quoting to four, at least, decimal basis points in the way the market convention quotes and sometimes even five.
SM: Right. Okay, so getting back to that ticker I was looking back at a year ago, so beginning of April 2022, Canadian dollar at that point was around 80 cents. It's down to 73.443, whatever that is now, six and a half, seven cents feels like a significant drop. Do you know what were the main drivers of that difference?
SO: Looking back a year or so ago, we had an expectation that rates would start to rise. We thought that as we emerge from COVID, global economy would start to pick up a bit more steam. China would be coming back on stream, demand for commodities would rise, therefore driving commodity prices a bit higher. So that was a kind of constructive backdrop for the Canadian dollar. A lot of the things that we expected to happen actually materialized. We had higher rates in North America. But it turns out that the Federal Reserve started to raise rates a bit more quickly. And in fact, both in Canada and the U.S., we saw one of the fastest tightening cycles I think we've ever seen in, certainly in the modern economic era, rates have never risen as aggressively or as quickly in North America as they have over the past year. So that in and of itself, the fact that the Fed Reserve was raising interest rates, whereas most of Europe and Asia Pacific were kind of sitting on their hands at that point, gave the dollar a broader lift. And it's very hard for the Canadian dollar to differentiate itself from the U.S. under those circumstances. The CAD actually appreciated quite strongly on the crosses. When I say the crosses, I mean other currencies, non-U.S. dollar currencies. So, the likes of the euro, the pound sterling and the yen. But it couldn't make any headway against the U.S. dollar because the U.S. dollar was rising against all currencies and the CAD had a pretty good year last year, just not against the U.S. dollar in the way that we expected.
SM: And when you say CAD, you mean the Canadian dollar, right?
SO: Yes. Whenever someone in my role was talking about the dollar, that is 100% of the time talking about the U.S. dollar.
[both laugh]
SO: And when we're talking about the CAD, the CAD refers to the Canadian dollar.
SM: Okay. I think for many Canadians, most of us live within whatever it is, 100 kilometers of the U.S. border. The main way that we would think about the value of the Canadian dollar versus the U.S. dollar is what our purchasing power might be if we're going to do any cross-border shopping.
SO: Yeah
SM: But is there such thing as Canada's currency being too valuable? And I guess maybe the question sort of is who benefits when the Canadian dollar is low and who likes it when it's high?
SO: I mean, we are generally a country of export of goods to the U.S. So a weak or a somewhat softer Canadian dollar generally suits our export of base. On the other side of the coin, we have to import a lot of foodstuffs from abroad. Farmers, people in other businesses that have to invest in large, very expensive capital goods, probably talking about importing that equipment from either Europe or the U.S. and will probably prefer a stronger Canadian dollar. It will make those purchases a little bit cheaper. So there's not a right or wrong answer effectively to this. It depends on where you sit across the economic spectrum. For the average person, a somewhat softer Canadian dollar probably is an issue when we're talking about cross-border purchases or vacations. Too weak a Canadian dollar, makes it expensive to travel to the U.S. and buy goods down there. Equally, when the Canadian dollar is strong, property prices look pretty attractive. And that was certainly the case in the sort of mid 2000s when the Canadian dollar was at par or close to that, you know, tremendous amount of Canadians took advantage of that to purchase property and make other investments down in the U.S. So it depends on where you sit. There's no right or wrong answer to that. When we look at the sort of long-term economic history of the Canadian dollar, we can see that things like the ten year moving average for the exchange rate, the 20-year moving average for the exchange rate, the mean of the last 30 or 40 years in purchasing power parity, all these various long run measures of the Canadian dollar’s performance, they all kind of coalesce around that 80 to 82 cent point. And if someone was to ask me to stick a pin in a rate that was comfortable for everyone, I'd probably put it in right around there. That’s an exchange rate I think that most people could live with.
SM: …On either side.
SO: On either side. But, you know, we're rarely at that point or holding around that point for any significant length of time.
SM: Right. Last question for you, where do you see the Canadian dollar going in, say, six months?
SO: So I still think there's a bit of upside in the Canadian dollar here. Our view is that we've probably seen the best of the U.S. dollar in this long run cycle. Our view for quite some time has been that the U.S. dollar will probably peak out when the interest rate advantage and the growth advantage that the U.S. dollar has benefited from strongly over the last couple of years starts to show signs of weakening and I think we're probably at that point now where we may not be quite the end of the Fed tightening cycle. Markets feel that we are. The house forecast at the moment calls for one more quarter point hike in the not-too-distant future. So whether we get that or not, I think looking beyond the next few months, markets are pricing in the eventual turn in the rate cycle and it seems quite likely, looking at market expectations, market pricing at the moment that markets feel that interest rates when they do start to fall, will probably fall over more quickly in the U.S. than much of the rest of the world. So that may or may not mean Canada. But it seems to mean, certainly relative to Europe and going back to that idea of the dollar being the 800-pound gorilla of the FX market, the euro is a pretty decent second best on that. So the trend in euro dollar, what the U.S. dollar does against the euro has a pretty huge influence on how other currencies tend to trade. The euro-dollar exchange rate is the kind of benchmark that we look at to try and assess, you know, the broader trend in the U.S. dollar. Now there will be some currencies outperform or underperform relative to that, but we think the euro could strengthen a little bit. It's probably looking fundamentally still quite cheap at the moment. So the euro has the potential to strengthen, I think, a bit more in the next 12 to 18 months. If we're right in our view, and if market pricing is correct in its assumptions, and that should pull the euro up a little bit against the U.S. dollar and it should give the CAD an opportunity to, I think, reflect some of the sort of underlying fundamentals have tended to be pretty decent growth, still relatively constructive outlook for the resource sector should give the CAD an opportunity to pick up a few cents against the U.S. dollar.
SM: So I should plan an American vacation, not a European one.
SO: [laughs]
SM: All right. Well, I think we will leave it there. Shaun, thank you so much for coming today. Really appreciate it.
SO: It's my pleasure.
SM: I've been speaking with Shaun Osborne, Managing Director and Chief Currency Strategist at Scotiabank. The Perspectives podcast is made by me Stephen Meurice, Armina Ligaya and our producer Andrew Norton who is too tall for the spinning teacups, but too timid for Splash Mountain.
