Pictured: Rob Bollé (left), Regional Manager, AFEX Los Angeles, and Kyler Koebel (right), Regional Manager, AFEX Vancouver
THE SPECIAL RELATIONSHIP
The US and Canada have long enjoyed a strong trading relationship. The United States is Canada’s largest trading partner: daily volume of the USD/CAD pair is approximately $275 billion US (about 5% of the $5.3 trillion daily foreign exchange market volume). This is certainly nothing to sneeze at!
The bilateral trade between the United States and Canada covers a spectrum of products and services, including raw materials and commodities (steel, aluminium, oil and natural gas from Canada), finished and semi-finished products (electronics, computers and biotech), as well as intellectual property, including talent and film and television production.
With such interconnectedness, volatility in the USD/CAD exchange rate affects both economies and businesses on both sides of the border. Getting a handle on market dynamics and mitigating currency risk is an important part of the day-to-day. The following discussion will outline some causes of the recent USD/CAD volatility, and strategies and approaches to better manage FX exposure.
EXCHANGE RATE VOLATILITY
Before firming a bit in July, the Canadian dollar had been trading close to its lowest levels against the U.S. dollar in almost a decade. While it traded in the high 1.20s (USD/CAD) for the last quarter of 2017, strengthening further in January of 2018, it struggled since, touching 1.36 in January 2019 despite positive economic data.
In May of 2018, U.S. President Trump announced tariffs on Canadian steel and aluminium imports and in June Canada responded with tariffs of its own on U.S. imports. The negotiating tactic may have had the desired effect, weakening the CAD while the United States-Mexico-Canada Agreement was being hammered out.
The Canadian dollar continued its slide through the end of the 2018, losing more than 10% against the U.S. Dollar. Despite the tariffs having been lifted, and the USMCA on its way to ratification, the weakness persisted until July 2019 when Canada announced stronger-than-expected economic data.
Nonetheless, the Bank of Canada’s 10 July update underscored the uncertainty, pointing toward recovery and a firmer footing for the loonie, but with measured caution. The US economy appears to be slowing, and the trading environment is still volatile.
Source: NETDANIA
A DELICATE BALANCE
The balance of trade, geopolitical events, commodities pricing, and interest rate differentials are major drivers in currency movement.
This USD/CAD movement has some positives. Canada is a net exporter: the weaker loonie makes pricing of Canadian goods more competitive in the global markets (though the China-U.S. uncertainty weighs heavily).
Canadian investment in the United States has appreciated with a stronger greenback, particularly in the Southern California region. And U.S. film and TV production is booming in Canada due to a softer loonie and generous tax breaks
With a softer currency, though, Canadian importers are faced with higher pricing for the goods they purchase, and Canadian consumer spending has been sluggish. Higher oil prices have not yet translated into gains for the loonie, making the economy even more reliant on exports for growth. The Bank of Canada bank has kept interest rates unchanged, while the US Federal Reserve recently cut interest rates to keep the booming economy from overheating.
The closeness of the Canada-U.S. relationship means that U.S. actions like the escalating trade war between United States and China, also affects the Canadian economy.
What does it all mean, then? Guaranteed uncertainty ahead.
MANAGING CURRENCY RISK IN VOLATILE MARKETS
While no one can predict the future, it’s wise to explore ways to protect your margins and hedge currency risk in a volatile market. Options range from rate orders to forward contracts, that fix an exchange rate for a given period, to options structures that allow you to take advantage of market movements in your favour.
The first steps, though, are determining your strategic objectives and your exposures. Here are some questions you should consider:
• Do you have a budgeted rate for your FX that you would like to achieve?
• How frequently are you sending or receiving foreign funds?
• How long is a typical sales cycle, from order to delivery and payment?
• Are you able to reprice your goods due to FX market movement?
• Would your business benefit from knowing your costs upfront?
Speak with a trusted and experienced FX professional for advice on planning and on market dynamics. They can offer guidance on tools and approaches that help you meet your goals.
HEDGING TOOLS
As noted above, different tactics exist that help you manage risk. Which tools, and how you use them, depend largely on your business goals. Following are descriptions of some hedging tools and how they work.
Spot Transaction
The simplest FX transaction is the spot payment. If you have a single payment due within the next few days, you purchase the foreign currency at the prevailing market rate for same-day, next day or two-day delivery.
Rates change constantly—the global foreign exchange market trades 24/6. The rates you see on line are typically “interbank” rates (what the largest banks charge each other), and often delayed. Most commercial providers will charge a “spread” over the interbank rate that will vary depending on the size and frequency of your payments.
Confirm the rate and the delivery (and any additional fees you or your beneficiary will be charged) with your provider.
Rate Order or Market Order
If you have a target rate at which you’d like to buy your currency, you can place a Rate Order that will fill when the target rate is reached. While the usual term for a rate order is two weeks, the order can stay in the market any length of time—even a couple of hours in a fast-moving market. Your provider can advise you on a suitable target and term and notify you when the rate is reached.
LOCKING RATES WITH A FORWARD CONTRACT:
Canadian exporter
Noel owns a Canadian auto parts manufacturer and contracts to sell custom parts to an Irvine-based automotive dealer, who wants to pay him in U.S. dollars.
The USD Is strong when they agree terms, so Noel prices the contract at US$400,000. He buys a six month forward contract to lock in the rate on the incoming USD.
US$400,000 * USD/CAD 1.36 = CAN$540,000
By the time the invoice is due, the CAD has strengthened by 8% against the U.S. dollar (USD/CAD 1.24). If Noel had not locked in the rate, he would have received only CAN$496,000, a loss of CAN$44,000.
Forward Contract
A forward contract allows you to lock the exchange rate for a fixed period (up to 24 months with many major currency pairs), typically with only a small deposit so you don’t tie up cash flow. Any premium over spot rates will be determined by the interest rate differential between the currency you are buying and the currency you are selling.
A forward contract is not designed to generate profits, but to protect them: you know the exact rate you will need to pay when the invoice is due, which makes planning easier. You are committed to purchase the currency at the locked-in rate when the contract ends, though, wherever the spot market is at the time.
There are two standard types of forward contract. A fixed forward has a specific end date, and a flexible forward can be drawn down at any time over the term.
For example: If you have an invoice due in three months, a fixed forward is probably the better choice. If you have several payments due over the course of the next three months, you would choose a flexible forward.
LEVERAGING CURRENCY WEAKNESS:
Filming in Vancouver
David is a Los Angeles-based independent producer/director who has secured funding to make a feature from his award-winning short film. He plans to shoot in Vancouver, registering the project in the United States and Canada as a separate entity.
His above-the-line costs are minimal—no marquee names—and he budgets the film at US $1.1 million, raising funds from American investors while his Canadian co-producer secures Canadian investors. He plans a 2-week shoot on locations in and around Vancouver.
Hiring crew on the ground in Vancouver qualifies him for local and national labour tax credits. As he’s expecting $CAN200,000 in tax credits, he borrows $US100,000 in finishing funds from a US film financier, knowing it will take several months to receive the tax refund
David’s Canadian co-producers’ investors are funding 35% of the budget, and David converts a large part of his U.S. funding into Canadian as the exchange rate is favourable. This acts as a natural hedge because he knows he is going to spend these funds in Canada.
He will convert additional funds from the United States to Canada as he needs them.
After scouting locations, hiring extras and crew, the film is ready to roll.
Currency Options
A currency option is a specialized structured instrument that protects you on the downside, yet allows you to take advantage of any upside if the market moves in your favour. This is a key difference from a forward contract, where the rate is the rate and you are committed no matter which way the market goes.
There are many different structures: some require a premium and others do not. Costs can vary and depending on the structure, pricing could even improve on the going spot rate. An options specialist can advise on the best structure for your business. (Currency options are licensed products; not all FX providers are able to offer them.)
WHAT THE FUTURE HOLDS
For businesses, market movement in either direction can affect profit margins and make planning difficult. Given the strength of the United States economy over the past 18 months, and President Trump’s willingness to use tariffs as a blunt weapon in trade talks (consequences to the US economy and other trading partners be damned, there will be ripple effects with many trading partners. If the U.S. dollar strength continues (much to the President’s displeasure), imports are more attractive to U.S. buyers while U.S. exports are expensive. Buyers of U.S. goods could well seek out different sources for similar products.
As the U.S. is a net importer, a decline in exports or retaliatory tariffs on imports could contribute to the deficit (which reached a ten-year high in the first half of 2019), affecting the economy’s momentum. This could also have repercussions on Canada and Mexico, so everyone is watching closely.
Canadian exporters, on the other hand, could take advantage of the weaker loonie. Importers are not so fortunate, as pricing has increased, making hedging a necessity for protecting profits. There is some optimism about the loonie finding a stronger footing in the next few months as oil prices have risen again, but there is no certainty.
The state of the USMCA has also caused some jitters: Mexico has already ratified the Agreement, and Prime Minister Trudeau introduced legislation in June to start the ratification process in Canada. The U.S. Congress has not yet set a date for a vote.
As Canada faces Federal elections in October 2019, and the United States in November2020, volatility is a given, at least for the near future, no matter how you slice it.
PLANNING AHEAD: Don’t go it alone
As we get into the doldrums of August, it’s a good time to consult a foreign exchange professional who can give you an objective analysis of your exposures and recommend tools and approaches to help you manage currency risk.
Beyond your bank’s foreign exchange desk, there are foreign exchange specialist companies whose services range from moving money efficiently from point A to point B, to providing market insight and advising on hedging and risk management. Think about what’s most important to you and how you like to work as you explore your options.
Advantages of working with a specialist can include more proactive service and richer strategic support, and more transparency on rates. Some specialists even offer multi-currency holding accounts free of the fees most banks charge. These allow you to send, receive and hold different currencies in a single account. You can hold the funds for future payments, saving on double conversions. or convert the currency when it makes business sense.
Do take the time to understand the pricing structure and the capabilities on offer. And make sure the specialist Is fully licensed and has depth and experience in the market. Some banks and specialists work through intermediaries and partners, which can delay payments and add to the cost.
Don’t discount chemistry. Find a partner who offers transparency, the level of service you need, a full portfolio of solutions that help you meet your objectives, and whom you can trust as an advisor and a resource in navigating the complexities of the FX markets.
In any event, a trusted provider and a sound strategy will give you peace of mind in uncertain times.
About AFEX
AFEX pioneered personalized foreign exchange solutions, providing a tailored approach since 1979. With offices across the United States and Canada, Asia-Pacific and Europe, we are a trusted business partner to 35,000 individual and commercial clients around the world, in a wide range of businesses. We are licensed and regulated in every jurisdiction where we operate.
Our unmatched payments infrastructure and state-of-the art payments technologies are the foundation for our customizable, cost-effective, and flexible global payments and risk management solutions. We help take the complexity out of foreign exchange so you can focus on your business.
To learn more, please visit afex.com or request a call back for a free, no-obligation risk consultation with one of our industry experts.
Robert Bolle, (818) 728-3266 rbolle@afex.com
Kyler Koebel, (604) 638-0228 ext. 1403 kkoebel@afex.com