CAD Outlook: Trade turbulence offers contrarian opportunity to hedge USD exposure

The Canadian dollar (CAD) depreciated by about 9% in 2024 versus the U.S. dollar (USD), with half of this weakening occurring after the election of Donald Trump. In 2025, CAD continues to trade near five-year lows against the USD and remains undervalued (see Figure 1). An appropriate question for investors is whether or not to start hedging U.S. assets to take advantage of any appreciation over a one- to multi-year time horizon.

Figure 1: Overvaluation (+) or undervaluation (-) in CAD vs. USD

Source: Bloomberg, as of December 31, 2024. Valuations based on PPP¹ (OECD estimates). Dotted lines show +/- 1 standard deviation.²

The darker blue line shows the long-term fair value of CAD/USD (based on purchasing power parity [PPP]), while the light blue line shows the actual CAD/USD exchange rate. If the light blue line moves above the fair value line, then CAD is undervalued, and vice versa. Currently, the chart indicates the CAD is significantly undervalued.

Why warm up to the bruised loonie now: Our year-ahead outlook

We believe there are five reasons to start hedging USD exposure at current levels. The outlook is always the most important to consider, in our view.

1. Rotation: Opportunistically take profits on USD positions and rotate some exposure to CAD.

2. Valuation: CAD is undervalued on a short-term and long-term basis. Valuation is not very useful for near-term currency forecasting, but we find them useful to consider when there have been sharp moves, such as what we have witnessed since Q3 2024.

3. Positioning: Speculative positions among non-commercial investors show that net short positions in CAD are at record levels (see Figure 2). Such extreme positioning indicates peak negative sentiment and can precede turnarounds in the currency, while also limiting significant further depreciation (the latter which we witnessed on February 3, when CAD weakened amid trade war fears but not as much as other G10 currencies).

Figure 2: Investors have never been as bearish on the Canadian dollar

Source: Bloomberg, as of February 12, 2025.

4. The rates outlook: U.S.-Canada interest rate differentials, reflecting the relative performance of the economy, have been a key driver of the recent CAD depreciation—unlike the last time CAD traded at these levels in 2020 because of COVID systemic risk (see Figure 3). We think rates differentials may be bottoming out and will likely start to narrow this year given our expectation of more Federal Reserve (Fed) easing, a key driver of USD depreciation.

5. Material tariffs still less likely despite fears: For Canada, we believe Trump tariffs are ultimately a negotiating tool and can be more easily avoided compared to other countries: there are easy wins (border and defense spending) and the U.S. holds a trade surplus with Canada, excluding oil and gas. Trump’s delayed approach to tariffs since inauguration day means that actual implementation of broad tariffs is the main risk. Uncertainty itself is not enough for large risk premiums to exist, as during the 2017-2018 NAFTA renegotiations when premiums were modest.

Figure 3: Rates differential driving CAD weaker, not just Trump

Source: Bloomberg, as of February 12, 2025.

Longer-term outlook for CAD:

We believe the two- to three-year outlook suggest stronger CAD to the low 1.30s (in CAD/USD terms) as:

1. The Fed is projected to cut rates to at least 3.5% by end 2026 as further disinflation takes hold
2. Continued disinflation and cutting cycles globally buoys global growth and risk sentiment, as CAD is a risk-sensitive currency
3. Tariff risk premiums become fully priced out
4. A conservative government in Canada, as is widely expected, eases U.S.-Canada tensions and promotes sectors geared toward Canada’s comparative advantage (natural resources)

Moreover, Trump has a good rapport with Canadian conservative leader, Poilievre.

Two downside risks to CAD will offer opportunity: U.S. economy remains exceptional or Trump unleashes trade war

1. First is a hawkish Fed in response to an economy that continues to defy expectations. Strong U.S. GDP growth and recent job numbers suggest the economy could be maintaining its exceptional momentum. Sustained above-trend growth would pose a risk where inflation progress would stall near 3%. Such a backdrop would likely put the Fed on pause for 2025, pricing out cuts and boosting the value of the USD.
2. The other risk is Trump imposes broad tariffs. The currency is the first mechanism for an economy to absorb a shock such as tariffs, so we can expect the loonie to quickly depreciate by a few cents on news of tariffs, like on February 3. And there are plenty of tail-risk events ahead, with tariffs delayed until March 4, as well as the Trump-imposed deadline of April 1 for trade investigations to be submitted.

Should either risk materialize, we would see the resulting depreciation in CAD as an opportunity to hedge. As a rule of thumb to map these scenarios, should Fed rate cuts be priced out fully in 2025, USD/CAD is likely to trade to 1.48-1.50. Alternatively, should 25% tariffs be imposed (still low but not zero probability, in our view), USD/CAD is likely to break 1.50. We would view these levels as opportunities to hedge given our view that Fed hikes are still unlikely, and that tariffs will be temporary and push Canada swiftly to the negotiating table.

Portfolio positioning

In our flagship ETF portfolios, we began small hedges of USD back to CAD when it rose above 1.43, and we are looking to increase again on any weakness as outlined above. We have also shifted our underweight of Canada equities closer to neutral since late 2024. A stronger CAD vs. USD in the year ahead is one reason to consider rotating toward Canadian equities. While other factors are important, the currency is key: Canadian equities (S&P TSX) are highly positively correlated³ to CAD (see Figure 4).

Figure 4: Canadian equities are positively correlated to changes in the Canadian dollar

Source: Bloomberg, BMO GAM, as of Feb 5, 2025.