Currency Complexity

Few topics have been explored more closely than the determination of exchange rates. Currency moves can have significant impacts on the real economy as well as investment portfolios. According to the Bank for International Settlements (BIS), average daily turnover in the world’s foreign exchange markets in 2019 was approximately $6.6 trillion. Exchange-rate moves impact trade in goods and services and hence a nation’s total output and employment. Currency gyrations can also impact national inflation rates via their impacts on import prices. Exchange-rate moves can lift or depress corporate profits. Lastly, currency swings can wreak havoc on global investment portfolios, or provide additional return and low correlation with other holdings, especially in bond-heavy portfolios where currency moves are typically large relative to coupon payments.

There are effectively three approaches used to manage currency exposures: 

1. Hedge. Many bond portfolios are hedged. The appeal of bonds is that they offer modest cash coupons, but greater certainty of outcomes than other investments, such as stocks. Accordingly, noisy currency moves detract from the appeal of bonds, and are thus best minimized by using derivatives to hedge away unwelcome and inexplicable portfolio volatility.

2. Do not hedge. Equity managers often prefer not to hedge. That is partly because equity portfolios are expected to have higher volatility, so equity fund managers are less troubled by ups and downs currency oscillations can cause. Long-term oriented equity holders also generally believe that currency moves are random, meaning that over time currency gyrations will be noise rather than systematic sources of risk. Lastly, equity managers recognize that the companies in which they invest may currency hedge their income statement or balance sheet exposures on their own, meaning that portfolio-level hedging by the equity fund manager could be redundant or worse.

3. Actively manage currency risk. This is the approach of most macro bond managers. Macro managers base their decisions on factors such as relative growth and interest rates, cross-border investment flows and pattern recognition algorithms. Insofar as returns from currency moves are typically uncorrelated with returns on other portfolio assets, they offer opportunity to improve overall portfolio diversification.

An example of the importance of currency management is on display today. Ever since US President Joe Biden’s election victory in November 2020, the broad US Dollar Index has drifted lower. That has been a surprise as the United States has outpaced the rest of the world in rates of COVID-19 vaccination, arguably the best leading indicator for 2021 growth. Additionally, US bond yields have risen by about a full percentage point since the third quarter of 2020, and spreads between long- and short-term interest rates have mostly widened between the United States and other developed economies. Typically a widening of interest differentials would have supported a stronger US dollar, but not this time. One reason is that other factors beyond relatively small changes in interest rates can drive cross-border capital flows. Rotation in global equity markets away from information technology and growth stocks toward cyclicals and value shares, for example, tends to favor equity returns in non-US markets such as Europe or China, which helps lift their currencies in foreign exchange markets.

The unusual dollar moves this year are a reminder that active vigilance is required for proper currency management. That will only become more important as monetary policies begin to diverge. Following an extended period of common monetary policy responses to common shocks (e.g., the global financial crisis or the pandemic), central banks are now beginning to independently rethink their approach. The Bank of Canada and the Bank of England, for instance, have begun early exits from the extraordinary policies they adopted during the pandemic, whereas the Federal Reserve or the European Central Bank have resolutely reinforced their determination to carry on with super-loose policies. If monetary policies worldwide begin to diverge, currency moves are apt to become larger and accompanied by more frequent bouts of volatility.

 Currency exchange rates are complex beasts, endlessly befuddling the top minds in finance and economics, defying ease or simplicity, yet demanding our attention. Currency risk demands active decision-taking and, as currency swings get larger in the years to come, it is likely to be a more important part of investment portfolio management.

Stay tuned.

For truly independent views on where the future of currency is headed, see:  

US:  ”Three segments, multiple opportunities in Emerging Markets”, ”Diving into China’s Bond Market”, “China’s digital currency is a threat to dollar dominance” and our latest Macro Perspectives: “Growth, rates and inflation” 

Non-US: ”Three segments, multiple opportunities in Emerging Markets”, ”Diving into China’s Bond Market”, “China’s digital currency is a threat to dollar dominance” and our latest Macro Perspectives: ”Growth, rates and inflation” 

What Are the Risks?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Investments in foreign securities involve special risks including currency fluctuations, economic instability and political developments. Investments in emerging market countries involve heightened risks related to the same factors, in addition to those associated with these markets’ smaller size, lesser liquidity and lack of established legal, political, business and social frameworks to support securities markets. Such investments could experience significant price volatility in any given year. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the portfolio’s value may decline. In general, an investor is paid a higher yield to assume a greater degree of credit risk. High-yield bonds involve a greater risk of default and price volatility than other high-quality bonds and US government bonds. Treasuries, if held to maturity, offer a fixed rate of return and fixed principal value; their interest payments and principal are guaranteed.

Actively managed strategies could experience losses if the investment manager’s judgment about markets, interest rates or the attractiveness, relative values, liquidity or potential appreciation of particular investments made for a portfolio, proves to be incorrect. There can be no guarantee that an investment manager’s investment techniques or decisions will produce the desired results.

Past performance does not guarantee future results.