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Seeking to enhance diversification? Time to explore currency strategies

 

 

 

2018.05.25 - Header

 

 

 

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  • Forex strategies rely on a portfolio manager’s ability to exploit differences in the relative values of the world’s major currencies. To do this, specialists combine fundamental analysis and quantitative models to identify the currencies that seem over- or undervalued.
  • Forecasting currency movements is highly dependent on understanding the major drivers of FX markets, such as macroeconomic indicators, technical factors and investment flows.
  • Going forward, we believe that the major influencing factor will be inflation development and the normalisation adjustments in Central Bank (CB) monetary policies. In general, we think that the USD will weaken further in the medium term due to redirected capital flows, but we could also see some higher volatility and short-term divergences from this trend.
  • The benefit of these strategies to an overall portfolio, in our view, is more than just another source of investment return. A portfolio of active currency positions offers a “pure” relative value strategy with low correlation 1  to interest rate or credit markets. This is because investors express relative value views when buying one currency vs another.
  • In today’s market, an investment strategy with no correlation to the bond and stock market is invaluable. Quantitative easing2 has helped to reduce interest rate and credit risk premia, and the danger is that the ongoing normalisation of CB monetary policy will see these risk premia rise together. Currency strategies, with zero correlation to these risks, could help support portfolio diversification3, with the additional benefit of being highly liquid.

 

The What, Who and Why of foreign exchange markets?

The What: Foreign exchange (forex or FX) is a very different asset class, with various particularities, the most important of which is that there is no market beta4. The currency market as a whole cannot move in the same manner as bond or equity markets. One currency is always traded vs another currency (so, a pair trade) generating a transaction while overall the FX market is not moving. It is by far the most liquid capital market in the world. To put this into perspective, currency trading exceeds USD5tn a day, which is equal to more than two months of trading on the New York Stock Exchange and the NASDAQ combined1. This is not surprising, as many activities involve different currencies: borrowing, lending or investing in foreign currency, imports and exports, among others. While over 170 currency are traded globally, most of the volumes involve the USD, at around 88% of all transactions. In terms of pairs, the most liquid involve the other G3 currencies (the EUR and JPY), but we also note that trading in Emerging Markets currency has surged. This means that currently investors can benefit from a wide range of opportunities when investing in currencies.

FX is a very different asset class, with
various particularities: there is no market beta, the market is very liquid and open for trading 24 hours a day. The market structure is also attractive, as it is
characterized by a diversified base of
participants (ie, corporates, banks,
among others)

2018.05.25 fig 1

 

The Who: Unlike traditional asset classes (bonds and equities), FX markets are dominated by liquidity seekers (corporates, banks, among others), not by profit seekers. Trading in currency occurs electronically over-the-counter (OTC) 24 hours a day via a global network of dealers comprised of major international banks. The FX market is truly global, with major financial centres being the United Kingdom, the United States, Singapore, Hong Kong SAR and Japan. With the rise in EM currency trading, Asian markets are developing a more relevant role, with their combined market share rising (21% in 2016 vs 15% in 2013).

 

The Why: For non-financial players, such as corporations, hedging is the major reason for using FX markets. In fact, any transaction in a different currency compared to the base currency (such as import/export, investments, etc.) exposes an entity to the risk of fluctuations in a currency’s value which can be hedged by trading the currency pair involved in the transaction. In portfolio management, in contrast, two main situations should be identified when considering currency exposure in a portfolio.

As currency trading
involves no credit or
liquidity risk, with low
transaction costs and
is by nature relative
trading (one currency
vs another), it can be
an attractive way to
target returns that
have a low correlation
with other assets, like
equities, bonds, credit
and commodities

1. Portfolio with currency exposure: In this first case, a portfolio has a FX exposure. This is the case in which there are assets in the portfolio in currencies that differ from the base currency of the portfolio (ie, a EUR-based portfolio invested in US Treasuries). It can be a small and exceptional position or a vast range of investments in foreign currencies, which is mainly the case when we look at global bond, equity or emerging market portfolios with investments in local foreign currencies. In this case, there is a given currency exposure already in the portfolio which makes an important contribution to the performance and to the risk in the portfolio. Anything in a portfolio that influences risk and performance has to be known, evaluated, monitored and, most importantly, managed. There is a large range of possible ways via which this currency exposure can be managed, from a complete hedging of the risk to using fully active currency management. The approach and the style of currency management has to be chosen according to the investor’s goal and risk preference. There is no one-size-fits-all solution. For example, in a global bond portfolio, the predefined FX exposure has a significant impact on the overall portfolio performance and therefore becomes a vital part of the management. The active positioning in currencies away from the given benchmark weights represents an additional source of risk and performance just like active positions in credit and duration risk. Depending on the particular correlation, FX positions can reduce, stabilise or increase the overall risk of a portfolio.

2.Portfolio with no currency exposure in search of an alpha6 currency overlay: The second situation is that a portfolio that has no predefined currency risk and no original investment in foreign currency assets, but the investor is interested in actively including  currency positions for performance enhancement, diversification or risk management purposes. In fact, as currency trading involves no credit or liquidity risk (at least in the most liquid currencies), with low transactions costs, and is, by nature, a relative trade (one currency vs another), it can be an attractive way to target returns that have a low correlation with other assets, such as equities, bonds, credit and commodities.

It is difficult to forecast the
trajectories of currencies as
numerous factors influence
performance. However, there are
opportunities that, in our view, a diversified
multi-strategy approach with disciplined risk and position management can exploit

How to exploit opportunities in currencies

It is difficult to forecast the directions of currencies, as numerous factors influence performance

2018.05.25 tab 1

 

 

As the main drivers of currency moves change often and sometimes rapidly in FX markets, we believe that flexibility and diversification are very important. There is no single strategy available in the FX market that will allow a manager to produce systematically superior risk-adjusted returns. To achieve this, we believe it is important to use both judgmental and quantitative techniques by blending different currency strategies. The four major investment strategies to consider are, in our view: Fundamental, Trend, Carry and Options. They are based on the combination of a fundamentally driven macro approach, which is a judgmental and opportunistic approach (for Fundamental and Options strategies) and quantitative techniques (for the Trends and Carry Strategies).

 

2018.05.25 Fig 2

 

Different currency strategies combining
fundamental and quantitative techniques with varying time horizons can help in the pursuit of stable returns

Fundamental:

The fundamental approach is based on the analysis of the main factors thatcould drive fundamental divergences between currencies, such as capital flows, economic and political environments, monetary and fiscal policies, and current and capital account.
These strategic factors are tactically influenced by market risk on/ risk off behavior: for example some currencies, like the JPY of the CHF – tend to appreciate in times of higher volatility and risk-off moves, therefore creating short-term divergences in currency valuations which offer arbitrage opportunities.

Options:

Options are another source of potential returns in the FX market that allow investors to take views on currency volatility or the direction of a currency pair with a different risk profile compared to an outright position. Options are also useful risk management tools that can be used to hedge overall portfolio risk.

Carry model:

The carry trade is defined as selling low-yielding currencies and buying higheryielding currencies. This strategy can offer opportunities, but it requires serious monitoring of the fundamental risk of each country in order to be able to close a position in case of a sharp deterioration of country risk.

Trend Model:

The trend strategy exploits the momentum in the currency market, where it buys/sells currency pairs when momentum moves in a strong direction. Based on historical price data, this quantitative model can help to capture behavioral factors driving decisions to
buy and sell a currency and identify new trends or confirm existing ones in exchange rate movements. Trend-following strategies are ultimately self-fulfilling: if enough investors follow a strategy, it is likely to move the market.

All in all, we think that when investing in currencies, the main focus should be less on the forecasts regarding a specific currency and more on the search for the most appealing investment ideas based on their risk/return profiles and their risk contribution to the overall portfolio in order to build a well-diversified portfolio that can seek stable returns over time.

 

 

 

What to expect regarding FX in 2018

The synchronized global growth upsurge, together with Central Bank policy, have been and will continue to be the key themes for FX markets this year. It is important to note that while “trade” has recently become a major topic, especially due to more aggressive US policies, our baseline scenario is one of non-escalation into a full-blown trade war and, as such, recent rising risks might ease through the year.

 

 

USD

The medium term outlook is negative for the US dollar. Given the currency’s strong appreciation in 2014-2016, a correction was expected. We would also note that the economic cycle in the US is more mature than in other developed economies, a situation that historically has coincided with a weaker currency. Moreover, other elements could exert downward pressure on the US dollar, such as a potentially continuing flattening curve in the US (which would make the US Treasuries less attractive for investment on a hedged basis) and US fiscal stimulus. Investors appear to be particularly concerned about the impact of the large fiscal package so late in the US cycle, which could lead to increasing inflationary pressures (weighing on the valuation of the currency) and a deterioration in the current US fiscal deficit. With regards to the recent US dollar rebound, we interpret this move as mostly driven by technical aspects and risk sentiment. Given the extreme short positioning of investors on the USD, a catalyst such as the recent disappointments on Eurozone’s macro data can give the USD price momentum. The diminished market’s concern on geopolitical threats like the situation in North Korea and the risks of a trade war between US and China have also supported the resurgence of investor’s sentiment towards the dollar. Uncertainty surrounding the Italian political crisis has contributed to weaken the EUR and favor the USD. However, we believe the trend on the USD for the medium term is still a downward one, as we expect to see better data in the Eurozone (and the other major economies) and the comeback to a more hawkish rhetoric from ECB and the major CB.

 

The synchronized global growth upsurge, and Central Banks policies have been and will continue to be the major themes for the forex markets this year

Other G10

Monetary policy, in particular, remains the key variable for the majority of G10 currencies. Among the G3, the EUR last year has been particularly boosted by a shift in the ECB communication regarding monetary policy while indication that BoJ has started discussions on how to begin to withdraw from its bond buying program has benefited the JPY.
We maintain a constructive view on both currencies, as macroeconomic fundamentals and valuations are supportive, especially for the JPY, which is extremely undervalued. Note that rising trade risks have also provided extra support to the Japanese yen due to its safe-haven status and, thus, corroborate a positive view on the currency’s performance this year.
More hawkish stance by the respective CBs have also clearly helped other major currencies. It is very interesting to note that the long-term positive correlation between petro-currencies and the oil price has not consistently held up in the past few months, as the rising oil price did not reflect currency appreciation, e. g., the Canadian dollar (CAD) and the Norwegian Krona (NOK). Such a relationship was somewhat re-established only when CBs (i) offered more hawkish communications and/ or (ii) started raising rates. While Norges Bank moved in this direction late December 2017 and the NOK is currently the second-best performing currency so far this year against the US dollar among the G10 currencies (after the JPY), the Bank of Canada is currently on hold since January, after having raised rates three times since July 2017. A less accommodative CB and strong economic activity are both supportive of the CAD. However, uncertainties over trade (e.g, negotiations on NAFTA with the US) have hit the currency and might continue to add some noise, but mostly in the short term, in our view.
Regarding the pound, while monetary policy might play a role for the currency – we note that the BoE has been extremely data depend and thus depending on inflation figures, a rate hike cannot be ruled out - politics remains the most important driver of the currency. We highlight that the second semester is going to be particular important as a Brexit transaction agreement is expected to be settled. For other major economies, where monetary policy stances are still very accommodative/ dovish (ie, Sweden, Australia), currency performances have been more muted. With regard to the Swedish krona (SEK), strong economic fundamentals and an  extremely cheap valuation make it very attractive. However, we highlight that a long position should be taken mostly in the H2: as long as inflation figures remain well behaved, we expect the Riksbank to change its monetary policy stance only when the ECB shift theirs.

 

Country differentiation within EM is becoming more relevant as global
liquidity peaks and volatility increases

EMFX

The global backdrop supporting appreciation in EM FX remained in place at beginning of 2018. A strong global trade rebound, global rates rising in line with market expectations, positive growth surprises from China, and a weak USD, among other factor helped EM FX. However, these tailwinds for EM FX have started to fade, due to USD strength and Treasury yield bonds on the rise. We have a more ‘cautious’ view on EM FX overall as an asset class, although we believe there is still room for selective opportunities in EM currencies based on our assessment discussed below. It is important to highlight, country differentiation within EM is becoming more relevant as global liquidity peaks and volatility increases. We expect USD to remain generally weak, but don’t forecast further incremental weakness to the extent seen at the beginning of 2017. EM-DM growth differentials should increase marginally or flatten going forward through 2018 as an acceleration in global growth is shifting from China to DM/other EM. Incremental EM export volumes appear to be cooling after extremely strong growth in 1Q17 (base effect). We do not expect a significant rally in commodity prices to drive EM FX in 2H18. This is a key component to capital flows into EM. The differences between local and DM rates are expected to narrow, marginally supporting hard currencies. From the perspectives of EM CB, we expect less of an ‘easing’ bias in 2018. Based on our assessment, EM rates for 2018 should be determined mostly by output gaps, not by inflation gaps, as inflation in most EM (except Turkey) should stay within CB targets. In addition, we expect EM CB to continue to accumulate FX reserves at least to pre-taper levels as EM inflation should remain (broadly) low and within CB targets. Risks from rising US rates are a key trigger for an EM FX selloff, and the busy political calendars in many EM will continue to add more volatility in 2018.

 

However, we continue to see value in selective EM FX for the following reasons:

  1. High-yielding FX carry is still attractive in some EM
  2. Short-term valuations look a bit stretched, according to our models, but on a mediumterm basis, there still looks to be enough room for selective EM FX to appreciate.
  3. This year, we continue to prefer relatively cheaper currencies, with high carry/low volatility and countries with low external vulnerability.

We think it is unlikely
for China to use large
depreciation of its
currency as a tool of
retaliation

Lastly, uncertainty regarding US ‘protectionist’ measures and the application of higher US tariffs should be seen as negative for the USD, as protectionism is generally associated with a weaker USD. However, if we were to see substantial declines in US equity markets and if global trade were to experience a significantly negative impact, then the USD might actually benefit on risk-off trades vs other currencies, including those of EM.

However, the latest developments suggested that China is working in multiple directions to push for a deal with US to avoid serious escalations. In any case, we think it is unlikely for China to use large depreciation of its currency as a tool of retaliation, as it would threaten China’s own financial stability, with potential global impacts to hurt China’s bargaining power, while RMB internationalization to suffer. China does not want to damage its reputation as an attractive place for portfolio investment, particularly after it was included in new benchmark indexes. The impact on the rest of EM is dependent on their integration of supply chains with China and the extent of their exports of technology products. However, Asian currencies in particular would be impacted by any significant depreciation in China’s currency. Hence, the trade issues is likely to increase EM FX volatility in next few months without significant depreciation.

 

1 Correlation: The degree of association between two or more variables; in finance, it is the degree to which assets or asset class prices have moved in relation to each other. Correlation is expressed by a correlation coefficient that ranges from -1 (always move in opposite direction) through 0 (absolutely independent) to 1 (always move in the same direction).
2 Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy by buying financial assets from commercial banks and other financial institutions.
3 Diversification does not guarantee a profit or protect against a loss.
4 Beta – Beta measures an investment’s sensitivity (volatility) to market movements in relation to an index. A beta of 1 indicates that the security’s price has moved with the market. A beta of less than 1 means that the security has been less volatile than the market. A beta of greater than 1 indicates that the security’s price has been more volatile than the market.
5 Source: BIS “Triennial Central Bank Survey: Foreign exchange turnover in April 2016”, September 2016. The same source applies for the other statistics on this page. Turnover in NASDAQ and NYSE Group refers to 2016 average daily turnover value (electronic order book) in 2016 from the World Federation of Exchanges, assuming 22 trading days in a month.
6 Alpha: The additional return above the expected return of the beta adjusted return of the market; a positive alpha suggests risk-adjusted value added by the money manager versus the index.

 

 

CROSNIER Laurent , Head of Global Fixed Income
KWOK James , Head of Currency Management at Amundi London
DI SILVIO Silvia , Fixed Income and FX Strategy
FORTES Roberta , University of Paris 1 Panthéon Sorbonne
GON Abhishek , Fixed Income and FX Strategy
KOENIG Andreas , Head of Global Forex
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