By CHRISTIAN NOLTING
THE foreign exchange (FX) markets have been regarded by investors as an asset class that offers them the opportunity to diversify their portfolios from other asset classes like stock and bonds and an alternative source of excess returns.
Around US$1.7 trillion is traded on the FX market each day, more than twenty times the daily turnover of the New York Stock Exchange and three times that of the US government bond market (Source: Deutsche Bank Global Markets). To this end, trading strategy indices – which simply refers to a range of indices that track the performance of particular FX trading strategies such a Carry, Momentum and Valuation – are available in the market.
Based on studies that Deutsche Bank has conducted, FX returns have a very low correlation with bond or equity market returns. Between 1980 and 2006, they had a 0.05 correlation with equities and a minus 0.21 correlation with bonds. Equities and bonds, meanwhile, had a 0.26 correlation rate over this period (Source: Deutsche Bank Global Markets). In this regard, we have also observed that positive returns can be generated by pursuing a combination of the above widely-known trading strategies. What is less widely known is that the introduction of FX in a properly constituted portfolio of other assets can actually reduce the probability and severity of draw-downs. This means that many participants in the FX market trade to hedge exposures.
One aspect of the foreign exchange markets is the large number of market participants that transact on a non-profit seeking basis. Professional investment risk-takers, dedicated to profiting from foreign exchange markets, only make up around 25 per cent of market participants, as opposed to around 80 per cent or 90 per cent in other capital markets (Source: Deutsche Bank Global Markets). The other market participants, such as central banks (which might intervene to enact government policy) and corporations (which typically transact to finance a specific deal) do not seek to generate profits as their primary motive for foreign exchange market transactions.
Factors affecting FX market
Macroeconomic situation
Changes in a country’s macroeconomic situation can have a major influence on the value of its currency. Foreign exchange traders pay close attention to countries’ economic and political situations when making their decisions. In the long run, the relative strength of a nation’s economy is often reflected in the strength of its currency. An economy that is growing quickly will likely attract investors from abroad seeking higher returns.
On a daily basis, economic data releases, policy decisions, and political events cause economists and traders alike to reappraise their outlook on a country’s economy. These dynamics, along with technical factors are what may drive price movement in the shorter-term.
Interest rates
Most countries’ currencies have an overnight lending rate determined by that country’s central bank. For example, the US Federal Reserve Bank meets periodically to set the federal funds rate. Higher interest rates attract foreign investment and induce domestic investors to repatriate overseas funds, increasing the demand for the currency and making it stronger. Therefore, any move to increase interest rates or any development that could cause a central bank to increase interest rates usually tends to increase the interest in that currency.
Equity markets
In the United States and other developed countries, both the overall direction in equity prices and dramatic short-term moves tend to have an impact on the value of a country’s currency. Money flows into a country as its equity markets rise and reverses direction in falling markets. Additionally, the equity markets serve as a sentiment barometer for a country’s economic prospects. Put simply, the more positive sentiment for a country’s economy, the greater the demand for its assets.
International trade
A nation’s trade balance is vital in any assessment of its economic health and more specifically in measuring the strength of its currency. A trade deficit might cause a weakening currency, since more of the country’s financial resources flow out of the country than other nations’ flow in. For foreign exchange markets, any unexpected move away from a nation’s trade balance baseline will usually trigger increased trading and a price movement.
Another major international influence on the value of currency is the price of commodities particularly oil. A rise, but more especially a sharp, unexpected spike in the price of oil could negatively affect the currency of oil-importing nations, such as the United States, and positively strengthen the currency of an oil-exporter, such as Canada.
Interest rate arbitrage
As for interest rate arbitrage opportunities, many hedge funds and institutional investors engage in the foreign exchange markets to find additional yield. Countries, such as Australia and New Zealand, which have relatively high interest rates, attract funds from lower interest rate countries, such as Japan and the United States (carry trades). Sophisticated international investors move money between currencies, just as more conventional investors move money between different bond issues.
Growth-sensitive currencies still seem well-supported in the current environment where low rates in industrialised countries and increased household savings keep the hunt for higher yields going. We particularly like CAD (Canadian dollar), NOK (Norwegian kroner) and NZD (NZ dollar), less so AUD (Australian dollar), in Asia KRW (South Korean won) and IDR (Indonesian rupiah). Looking further down the road these currencies could yet be impaired by a change of US interest rate expectations, especially if changed Fed rhetoric caused the front end to rise.
Recent rhetoric of Chinese officials has fuelled expectations that a less rigid exchange rate policy may lie ahead. We expect any appreciation to be a gradual long-term process and not a one-off revaluation.
The lack of a unanimous stance of European nations towards their intra-European problems continues to weigh on the single currency. A hard stance towards Greece is generally perceived as euro-negative by the markets. A solution that envisages a prominent role for the IMF could send euro/USD down towards 1.30 in the short term. In the medium term to us, this appears to be a better solution than a purely EU-focused financing because of the IMF’s greater expertise and independence. A EU solution with the possibility of mutual political pressure could in the end undermine the confidence in the European institutions and the currency itself.
In their latest statement, the US Fed again sounded fairly dovish and hinted at a continuation of their expansive rate policy for the time being. The market currently is priced for two hikes of 25bps each until year end but with regards to the timing opinions still differ widely. If rate hikes start earlier than anticipated, expectations of a smooth hiking cycle are likely to lead to a stronger dollar. The trigger for a change in Fed policy has historically been the labour market. Also this time round we expect the new rate cycle to start when several consecutive months of substantial US job growth have been seen. In our view this should not occur before the summer and we only expect a mildly positive effect on the US dollar.
With the end of the Japanese fiscal year in March seasonal patterns generally start to become less favourable for the yen. Repatriations of assets into the yen normally fade around this time. Exports remain the key pillar of the Japanese economy and a strong currency is not in their national interest. We prefer to express our negative yen stance via crosses that embody the two extreme positions in the global recovery in terms of growth, inflation, correlation to stock markets and rate expectations. Examples of that would be long positions in NOK/JPY or CAD/JPY.
The writer is Lead Strategist, Asia Pacific & Regional Head of Portfolio Management, Deutsche Bank Private Wealth Management
This article was first published in The Business Times.
Diversifying into the forex market
