Currencies - Frenemies?

Unconstrained investment solutions

Currencies - Frenemies?

Some investors see the foreign exchange market as a volatile, risky venture, not for the faint-hearted. But, a professional and unconstrained investment approach has the potential to turn currencies into friends, rather than enemies.

With $4 trillion of daily transactions¹, the foreign exchange universe is the largest financial market in the world, yet it is often viewed warily by investors. The relationship between an investor’s domestic currency and the currencies in which their overseas investments are denominated may appear an unwelcome source of risk. However, for unconstrained fixed income managers it is common to anticipate the risk and opportunities from foreign exchange to enhance returns and/or protect their positions.

These are the ways currencies can be used to benefit investors:

1)    Access to a country: The fortunes of currencies tend to mirror their economies and underlying fundamentals. Strong currencies tend to come with strong economies, and vice-versa. Deficits – current account or government – or unstable political situations are quickly reflected in a currency’s exchange rate. This is because foreign exchange is a more vivid and liquid market than, for example, government debt. In Brazil, the exchange rate was impacted significantly as a political crisis unfolded in 2015 and 2016 and economic growth weakened. More recently a better economic and political situation has been reflected in a stronger currency.

This reactive nature allows investors to benefit from a country’s positive story, especially if they can predict it and buy when the currency offers value. This gives an unconstrained fixed income manager an alternative source of value when bonds may be fully priced.

2)    Additional return: Investing in the bond market of a different currency to your domestic currency can bring currency gains in addition to the coupon and price return of the bond. This could be a US dollar based investor who has exposure to local currency emerging market debt. In 2017, local currency emerging market (EM) government bond generated a return of 8.9% in local currency terms and a return of 15.21% in USD terms. In contrast in 2014/2015, weaker EM currencies detracted from bond returns. Currency return is one of the components of bond returns, apart from what investors can earn through coupon or price returns. The chart below shows the index returns from local currency EM government bonds in local terms and the returns valued in US dollars. An active manager will aim to enhance such returns by using their expertise to select currencies they feel are undervalued, where the market is maybe not fully pricing in a positive fundamental backdrop or where it might be focusing more on shorter term factors such as political events.

 

How currency can impact returns

Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

 

3)    Liquidity: Liquidity can sometimes become an issue as bonds bear different coupons and maturities. When dealing with remote or higher risk markets, buying or selling securities sometimes can take days. By contrast, currency markets are open 24 hours a day, five days a week, giving investors a bigger trading window. Some bond markets have barriers to entry for international investors, as investors need licences to be able to trade on markets. Investing in a country’s currency market, which doesn’t require a licence, can provide an alternative way of benefiting from a country’s positive outlook or for achieving a fuller portfolio diversification.

4)    Carry trade: In theory the foreign exchange market is liquid enough to prevent arbitrage (where one investor borrows in a low-interest country to invest in a higher interest rate country and make a profit), but these situations occur as markets are not always rational or do not share perfect information.

A good example is how investors have borrowed in yen or euros to purchase bonds in higher yielding emerging markets. Many bonds in the Eurozone and Japan have incurred negative interest rates in order to foster their economies, while those in emerging markets have sometimes  offered double-digit yields. 

5)      Protection – hedging: Some investors cannot stomach the occasional sharp swing in foreign exchange markets. In order to smooth outcomes, managers can use instruments, such as standardised futures contracts - or forward contracts, to hedge investment risks in their portfolios. They may also use the derivatives market in order to enter into a short position in a currency if they believe it will depreciate.

For example, some investors may have a short on certain Asian currencies as a hedge against a slowdown in China – in such case, were China to suddenly cause market havoc by releasing unexpected negative news, the currencies of its Asian neighbours could fall – making a short position on them profitable.

Conclusion

With $4 trillion of daily transactions the foreign exchange universe is much bigger than the $748 bn US of daily trading of US government securities, or the $550 bn average daily volume of the S&P 500 stock index. Being the largest-traded market in the world, the foreign exchange market offers opportunity for investors with either short-term, tactical approach, or for those willing to enhance a long-term, fundamental view. In this way, an unconstrained investment approach can turn world currencies from an unrewarded risk to one that offers opportunity.

¹ Currency trading averages about US $4 trillion daily according to the Triennial Central Bank Survey of foreign exchange and Over the Counter derivatives from the Bank for International Settlements. 

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