Investors are quite familiar with buying stocks and bonds. However, currencies rarely feature in the regular investor’s portfolio. However, watching the poles in Britain and wondering if Brexit is also attracting investors to the risk of large currency swings. It is not just the Brexit that may be making investors dizzy with the swings of the British sterling.
In recent years, currency volatility has generally been on the rise: Markets, economies and political dynamics are always in flux. Though understanding what persists through time is crucial to making intelligent investments, identifying how today’s environment differs from the past is most important. One undeniable source of divergence from the past is recent heightened currency volatility. For institutional investors, who have significant global exposure, currency volatility can wipe out gains from investments in other assets and add uncertainty to their portfolio returns. Alternative understanding the dynamics behind currency volatility, can help investors both appropriately hedge the risk in their portfolios and generate alpha.
Here are a number recent drivers of currency volatility:
- After the market impact of European Financial Crisis stabilized, currency volatility began to rise again as the US “Taper Tantrum” took effect. Rising US interest rates forced a sharp move in global rates and lead to a substantial pull back in capital from Emerging Markets. As one would expect, there is a strong relationship between interest rate volatility and currency volatility because the change in interest rates within a country make its currency more or less attractive to investors. The more interest rates move around, the more the attractiveness of one currency versus another changes. But, as you can see currency volatility and interest rate volatility in the US are diverging, which is a recent dynamic. Let us understand why.
- In the developed world, currencies have become an increasingly important lever of central banks to stimulate domestic economic conditions. This is because all developed world countries are at the end of their debt super cycles and are unable or unwilling to use the traditional interest rate channel to support spending. Historically, to cause an economic expansion central banks would cut interest rates to facilitate credit creation. The increase in borrowing would invigorate the economy and push growth above trend. However, with debt levels high across the developed world and interest rates at their lower bound this is no longer possible.
Though the story for each country is slightly different, they all suffer from the same problem: fading ability to stimulate economic growth and offset deflationary pressures. Japan has been experiencing deflationary stagnation for the past 15 years. The Eurozone is dangerously close to the same fate. The next big move for Australian and Canadian growth is likely down as their household sectors have not yet deleveraged and their commodities sectors have slowed. All developed world countries need or will soon need economic stimulation but interest rate policy will likely have very little direct impact.
- As distinct from interest rate stimulation, currency depreciation works through a few different channels and none of them require a pick-up in debt. Firstly, a falling currency has the immediate effect of boasting corporate profits through margin expansion. To the extent that a corporation pays costs in local currency (labor and capital expenditures) but earns revenues in a foreign currency, margins immediately expand on the back of currency depreciation. This contributed to corporate profits in Japan soaring after JPY fell consequent of the introduction of QE in 2013. The second channel is the boast to export volumes that occur when corporations either chose to cut their prices in foreign currency terms or accrue the competitive effects for goods that are priced in local currency terms to begin with. The third channel is the reduction in import volumes as domestic consumers and companies switch their spending away from expensive foreign goods to cheaper domestic goods. The fourth and final channel is the shift investment that occurs because of the improved competitive position. This is the slowest moving factor but it is nonetheless critical to long term growth. The impact occurs from both domestic corporations shifting investment away from foreign countries as well as foreign corporations shifting investment to country with the cheap currency.
- However, there is a problem with currency depreciation: it is a zero sum game. Whereas lowering interest rates can be done simultaneously to everyone’s benefit, getting your currency to fall has only one winner. The nature of currency markets creates a currency war mentality, which each central bank and government vying for the most favorable position. Export market share gains, global investment share gains and boasts to inflation all come at the expense of countries that do not depreciate.
This has of course led to conflicts among central bankers, some implicit, others more explicit. The latest iteration of these conflicts came in March when the US treasury “expressed concern over the [Japanese] authorities’ public statements on the desired direction of the exchange rate.” The Bank of Japan chief Horuhiko Kuroda regularly makes statements about the level of the Australian dollar and these statements often cause movements in the exchange rate in accordance with his comments.
In the current low growth, low interest rate environment, practically all developed world countries would benefit from a falling exchange rate. It is unlikely that Eurozone can make a full recovery without the Euro continuing to fall. The same goes for Japan as the BOJ continues to battle deflation and convince corporations to invest domestically. Similarly, Australia and Canada would welcome depreciation as it would boast domestic activity without leading to an expansion of household debt.
Despite the criticism that will come from other countries we expect central banks to generally act in the interests of the countries they serve. With interest rates at zero or below this means using increasingly stronger and stronger tools to support depreciation, such as expanding the quantity and type of assets purchased. Such policy will be a source of continue downside volatility for those currencies.
- But that is just one side of the volatility. There is also substantial volatility on the upside because the moves from central bankers get over-priced by the market, creating a temporal mismatch between when the speculators short the particular currency and when the real money flows come in. This is what happened to the euro several times over the past few months. As you can see, despite a substantial quantity of QE from the ECB the Euro has been subject to a set of very sharp upside reversals. Below you can see that the reversal of stretched speculative positioning can cause sudden reversals in the Euro’s downward trend. As volatility is increasing from both sides, it is likely that elevated currency volatility is here to stay.
- As political volatility rises, ranging from the risk of Brexit to regulatory changes in Europe and corruption charges in Brazil, currency volatility also follows. For example, despite the last cycle of QE, the EUR experienced upwards pressure due to European banks and corporations deleveraging by selling non-European assets. Debates about the Brexit and lack of clarity of a potential outcome next week on June 23rd has more than tripled the volatility of the British Sterling.
The rising currency volatility has two main implications to investors:
1) Your portfolio has implicit currency exposure already which can eat up returns. The first is to make sure you hedge your foreign equity and debt investments. Because currency volatility is higher it will compose a larger portion of portfolio returns. Unless you have a currency as well and that this view is the same direction as your asset view, you should insolate yourself from this source of volatility. Moreover, the currency volatility will likely work in the opposite direction as your asset view. Consider that a big driver of returns for stocks and bonds will be easy monetary policy. For example, a big reason for buying European or Japanese equities is because you believe the ECB and BOJ will continue to stimulate. But that will probably mean the Euro and Yen will continue to fall. If you are long the equities unhedged then you lose a good portion of these returns. The very thing you are trying to bet on will hurt you on the FX leg of the position.
2) Investors can use this source of volatility to your advantage. Volatility can present an opportunity for alpha and that alpha does not depend on underlying economic global economy assumptions and has low correlation to US stocks, for example. Because understanding currencies market is fairly complicated, investors may consider leaving that to the experts. There are funds that can take advantage of these opportunities. Capturing currency alpha will be particularly important in a world where the risk premium on traditional assets, such as stocks and bonds, become compressed. At some point, the only possibility for a large move in stocks and bonds will be to the downside, as described in Why the Economy is In Need of Fiscal Fuel. That will not be the case for currencies.
Read this Article by Katina Stefanova on Forbes