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Massive demand for CAD is generated through hedging transactions.
Canada's currency could be in for a structural tailwind as shifting pension fund strategies spur greater domestic investment and a reevaluation of foreign currency exposure, according to a new report by Desjardins Bank.
Canada’s pension funds, managing over CAD3.6 trillion in gross assets, are global giants in asset diversification. Historically reliant on foreign investments, particularly in U.S. equities and infrastructure, these funds have left much of their currency exposure unhedged, reinforcing capital outflows and pressure on the loonie.
But that may be changing.
In a new analysis, Desjardins notes that Canada's five largest pension funds hold roughly CAD1.1 trillion in foreign assets, about 80% of which are not hedged. “If even a modest increase in hedge ratios occurs, the Canadian dollar could significantly outperform its traditional macroeconomic anchors,” the report said.
The outlook comes amid a broader rethinking of foreign exposure, as correlations between the Canadian and U.S. dollars weaken. “The greenback’s safe haven appeal is being questioned,” the report noted, citing the USD’s underperformance during recent market sell-offs.
A shift in hedge ratios by Canadian pension funds refers to changing the proportion of their foreign currency exposure that is protected (or "hedged") against exchange rate fluctuations, specifically against movements between the Canadian dollar (CAD) and foreign currencies like the U.S. dollar (USD).
Current Situation:
- Canadian pension funds hold CAD1.1 trillion in foreign assets.
- About CAD0.9 trillion of this is unhedged, meaning the funds are exposed to foreign exchange (FX) risk, mainly movements in USD/CAD.
- These unhedged positions have historically benefited from a weaker Canadian dollar, which boosts the CAD value of their foreign assets.
What a Hedge Ratio Shift Means:
If funds decide to increase their hedge ratio, they would start converting some of their foreign currency exposure back into Canadian dollars using financial instruments like:
- Currency forwards
- Futures
- Options
- Or other FX derivatives
How It Works:
Here’s a simplified breakdown:
- Suppose a pension fund has USD1 billion in U.S. assets.
- If unhedged, the fund is exposed to USD/CAD fluctuations.
- If the CAD strengthens, the value of those USD assets declines in CAD terms.
- If the fund decides to hedge 20% of its exposure, it might enter into a currency forward contract to sell USD and buy CAD at a future date.
This action:
- Locks in the exchange rate for that portion.
- Reduces currency risk.
- Creates demand for CAD and supply of foreign currency in the FX market.
Implications for the Canadian Dollar:
When multiple large pension funds do this at once:
- Massive demand for CAD is generated through hedging transactions.
- That demand can push the Canadian dollar higher, potentially beyond what fundamentals like interest rates or trade balances would suggest.
- Desjardins estimates that even a small shift in hedging policy (e.g., a 10% hedge on CAD900B = CAD90B in hedging flows) could move markets significantly.
Why Would They Do This Now?
- The USD's "safe haven" status is eroding, making unhedged exposure less attractive.
- The Canadian dollar is undervalued on many metrics.
- There’s growing pressure for more prudent, long-term FX risk management.
Pension funds also face net cash surpluses, estimated at CAD105 billion in 2025, largely earmarked for investment. While most of these flows are likely to support foreign assets, political momentum is building to redirect more of this capital at home.
Last year's Fall Economic Statement introduced measures to encourage pension fund investment in Canadian infrastructure. Although described as incremental, Desjardins suggests further reforms could create a “win-win” scenario: enhanced returns for pensions and deeper capital markets for Canada.
"Even a 1% shift in asset allocation from foreign to domestic by social security funds would result in CAD10 billion of Canadian asset purchases," the report highlighted. A similar move by trusteed pensions could add another CAD24 billion.
Still, such transitions won’t be swift. Foreign investments have consistently outperformed Canadian assets in recent years, creating a high bar for reallocation. Strategic adjustments would likely hinge on improved local investment opportunities and clearer long-term policy signals.
For now, Desjardins expects pension funds to remain large buyers of foreign securities — and sellers of CAD. But if the shift in hedge policy materialises, the loonie could see "non-trivial appreciation" beyond what interest rate differentials or trade balances would suggest.