Canadian Dollar Volatility in 2025: Navigating Trade Tensions and Fed Policy Divergence

The Canadian dollar (CAD) has become one of the most contested currencies in 2025, caught in a tug-of-war between U.S. trade policy uncertainty, divergent monetary trajectories with the Federal Reserve (FED), and global geopolitical risks. As the U.S. threatens to impose 35% tariffs on Canadian goods outside the USMCA framework and the BoC lags behind the FED in rate cuts, investors face a paradox: a weaker CAD could harm exporters but create opportunities for those who position strategically in energy-linked Canadian equities and CAD-denominated assets.

The Twin Engines of CAD Volatility

The CAD's turbulence stems from two primary forces: trade policy brinkmanship and monetary policy divergence.

1. U.S. Tariff Threats and Trade Uncertainty:
   President Donald Trump's August 1 deadline for a new Canada-U.S. trade deal—threatened with unilateral 35% tariffs—has amplified risk premiums on the CAD. By early 2025, USD/CAD surged to 1.45, a five-year high, as speculative selling intensified. While the U.S. extended the deadline, the mere possibility of tariffs has kept the CAD under pressure. Energy and manufacturing sectors, which account for 12% of Canada's GDP, are particularly vulnerable. A 10% drop in Brent crude prices in 2025 further compounded CAD weakness, as energy exports face dual headwinds from falling commodity prices and potential U.S. tariffs.

2. Divergent Central Bank Policies:
   The BoC's projected rate path (2.50% by year-end) lags the FED's 3.75% benchmark, creating a 1.25-percentage-point differential. Historically, such gaps have pressured the CAD, as capital flows toward higher-yielding USD assets. However, the BoC's cautious approach—projected to deliver only two 25-basis-point cuts in 2025—has limited the CAD's decline. The BoC's July 30 decision to hold rates at 2.75% reflects its focus on inflation control, but markets anticipate a 2.50% rate by year-end, narrowing the spread with the FED.

Strategic Positioning: Energy Equities and CAD-Denominated ETFs

Amid this volatility, Canadian energy-linked assets and ETFs offer a compelling hedge. A weaker CAD enhances the competitiveness of Canadian exports, particularly in energy, while energy prices and trade normalization could drive a CAD rebound.

Energy Equities: Freehold Royalties (FRU) and Enbridge (ENB)

• Freehold Royalties (TSX:FRU):
  A royalty company with 24,000 U.S. oil well locations, Freehold benefits from higher crude prices and U.S. production growth. Its U.S. portfolio commands a 43% premium due to access to the Gulf Coast market. With a 40% year-over-year production increase and a 60% payout ratio, Freehold's dividend yield of 8.30% makes it a high-conviction play. Analysts project a 21% upside to $15.77 by year-end.

• Enbridge (TSX:ENB):
  As a pipeline operator connecting Canada and the U.S., Enbridge is well-positioned to benefit from global LNG demand and cross-border energy infrastructure. Its 25.13% stock return in 2025 and RBC's $63 price target highlight its resilience. A weaker CAD enhances the competitiveness of its U.S. exports, while its diversified operations (including 40 billion cubic feet/day of power generation opportunities) provide stability.

CAD-Denominated ETFs: XEG and XEN

• iShares S&P/TSX Capped Energy Index ETF (XEG):
  This ETF tracks 28 Canadian energy stocks, with 46% concentrated in Canadian Natural Resources (CNQ) and Suncor Energy (SU). Despite a 12.99% April 2025 drop, XEG has rebounded 5.93% in May and 5.54% in June. Its 3.25% YTD return and 33.59% five-year annualized gain make it a high-risk, high-reward bet on energy sector recovery.

• iShares S&P/TSX Energy Index ETF (XEN):
  A broader energy index fund, XEN offers exposure to 25 energy companies. With a 0.51% 12-month return and a 3.46% dividend yield, it balances income and growth potential. However, its risk-adjusted metrics (Sharpe ratio of -0.02) highlight the sector's volatility.

Hedging Strategies for 2025

1. CAD Forwards and Options:
   Firms with U.S. exposure should hedge against sudden CAD depreciations using forwards or options. The CAD's 7.7% depreciation in early 2025 (two-thirds attributed to risk premiums) underscores the need for protection.

2. Positioning for a CAD Rebound:
   If the FED delays rate cuts, the CAD could appreciate to 1.30–1.25. Energy ETFs and equities will benefit from a stronger CAD, as will CAD-denominated bonds.

3. Diversification:
   Pair energy investments with defensive assets like Evertz Technologies (ET) or Canadian government bonds to balance risk.

Conclusion: A High-Stakes Environment

The CAD's 2025 volatility is a double-edged sword. While trade tensions and Fed policy divergence pose near-term risks, a narrowing BoC-FED spread and energy sector resilience create opportunities. Investors who hedge against tail risks while positioning for a CAD rebound—and energy-driven recovery—stand to capitalize on this high-stakes environment. As always, monitoring geopolitical shifts and central bank guidance will be critical to navigating the uncertainties ahead.