FX markets in the Trump era

  • Since the US presidential election on November 9th, markets have generally welcomed the more conciliatory tone from the President-elect Donald Trump.
  • How might the changing economic environment affect currency hedging decisions, and what does this mean for currency returns?

Since the US presidential election on November 9th, markets have welcomed the more conciliatory tone from the President-elect Donald Trump. Contrary to expectations, developed market equities have outperformed, while bond markets have sold off on the back of infrastructure-inspired growth expectations and a step up in nominal and real yields. The US dollar has been the beneficiary; since the election, the US dollar has gained against almost all developed market currencies (although, as British Prime Minister Theresa May sought to soothe businesses’ Brexit concerns, the dollar fell marginally against the pound sterling). The Japanese yen has been the worst hit as the Bank of Japan’s recent commitment to zero percent yields has amplified the impact of a US yield curve steepening.

Emerging market (EM) currencies have received no exemption from the dollar’s rally, though declines are not dissimilar to those witnessed in developed markets. Unsurprisingly, losses have been most pronounced in the Mexican peso, while other currencies also expected to suffer from protectionist policies, such as the Taiwanese dollar and Indonesian rupiah, have not fared as badly. The relatively muted reaction in other emerging market currencies is likely the result of healthy national balance sheets and co-ordinated central bank action; according to several measures, reserve adequacy had risen following the rout in 2014/15, and these reserves were utilized effectively to promote stability while the market adjusted to a new equilibrium.

 

spot-currency-performance-1 spot-currency-performance-2

How might this affect the decision to hedge?

The election of Donald Trump has had a profound impact on markets and may mark the beginning of a new economic era; one which emphasises fiscal policy, protectionism, and entrepreneurialism. The consequent evolution of correlations, volatility, and interest-rate differentials in the currency markets will affect the trade-offs involved with any hedging program.

We note that the US dollar has begun behaving in a more risk-on fashion of late (foreign currency and equities have moved inversely) while volatility is elevated and interest rates have repriced upwards quite significantly. The evolution of currency/equity correlations is the most uncertain factor. On one hand, the expected change of the US dollar from a low-yielding to high-yielding currency and the resultant reallocation of global risk capital could encourage pro-cyclical behaviour in USD. Additionally, economic theory[1] would suggest that a shift in policy focus away from monetary tools towards fiscal policy would increase medium-term correlation between risky assets and the US dollar. On the other hand, however, we expect US Treasuries and other USD assets to maintain their safe-haven status among investors, contributing to counter-cyclical behaviour in USD.

How do these factors affect the decision to hedge? We find that in aggregate a US dollar-based investor hedging Eurozone equities will benefit from the changing environment outlined above. Changing correlations could mean that currency hedging becomes less able to reduce portfolio volatility, but higher US interest rates would increase the excess return added by a hedging program, such that an investor’s risk-adjusted return is still boosted by currency hedging.

Using Eurozone equities as an example, in the charts below we evaluate for an optimal hedge ratio, both from the perspective of volatility and risk-adjusted return. The increase in future currency volatility implied by the option market suggests the need to hedge more, especially if the current correlation levels[2] (between Eurozone equities and EURUSD) persist at around -0.2 (left panel, light green line). However, this correlation has been on a strong downward trend since late-2014, which likely reflects changing attitudes to risk as interest rates in the US normalize. If falling equity/currency correlations intensify, portfolio volatility would be reduced by hedging less than 100%, then from a volatility perspective the optimal point at which to hedge will be lower (left panel, dark green line). However, the changing interest rate environment (sustained low rates in the Eurozone and Japan and elsewhere, with expected increases in the US) also has an effect on risk-adjusted return.

In the ‘new normal’ era of lower returns, we find that any additional returns over and above the equity risk premium have a larger impact on risk-adjusted return. For a US dollar-based investor, this means that the higher future interest rate differential (implied by interest rate swaps), earned via hedging back to the US dollar helps to offset the increased volatility at higher hedge ratios. In the second chart below we show that the risk-adjusted return increases with more hedging. Therefore, considering portfolio volatility and risk-adjusted return in combination, a 50% hedge ratio would be a sensible choice under this regime change, and could increase risk-adjusted return relative to being unhedged by up to 25%[3].

 

volatility-and-ir-smile

Market volatility presents opportunities in currency

The election of Trump and the higher potential of both anticipated extreme events (e.g. Brexit, other European elections) and unknown extreme events (e.g., the Swiss floor) will present interesting opportunities within currency. Positioning a currency portfolio towards various FX risk premia enables an investor to undertake specific and well understood risks, and to exploit inefficiencies within the market. Many of these risk premia extend across asset classes, including carry, momentum, value, and structural opportunities in emerging markets.

The most important takeaway from the election is that the political shake-up underway implies more extreme policy moves and a greater degree of cross-country economic dispersion. We believe this helps to expand the opportunity set within currency in a number of ways. As real interest rate distributions become wider, carry returns will tend to increase; moreover, the trends in real interest rates are a major explanatory factor in medium-term currency moves which momentum strategies can exploit. This, in turn, can lead to dislocations from fair value, which provide favourable conditions for value strategies.

In emerging market currencies, further rises in US interest rates following Trump’s election could come as a headwind to short-term performance if investors redeploy capital based on relative yield opportunities, and if EM corporates begin to re-examine hard currency borrowing decisions. That said, the medium to long-run drivers of EM currency returns – productivity growth and real interest rate differentials – are expected to remain positive relative to the US and other core developed market currencies. Short-term drawdowns therefore present more favourable entry points for investment in emerging markets, while investing against a diversified basket of short developed market currencies can insulate against country-specific shocks and enhance return.

 

[1] In the Mundell Fleming economic model fiscal expansion under a flexible exchange rate regime leads to currency appreciation.

[2] Correlation is measured on a 36-month basis between hedged Eurozone equity returns and long euro short US dollar currency returns.

[3] Calculated analytically based on the given assumptions and the formula for variance of a portfolio consisting of two components (A=FX; B= asset; W = 100%)

Assumed volatilities based on 1-year current and forward option implied volatility. Assumed interest rates based on 1-year current and forward swap rates. Assumed local EMU equity return based on EUR risk free rate plus 3.5% expected equity risk premium.

 

 


Record is authorised and regulated by the Financial Conduct Authority in the UK, registered as an Investment Adviser with the Securities and Exchange Commission in the US and registered as a Commodity Trading Adviser (swaps only) with the US Commodity Futures Trading Commission, is an Exempt International Adviser with the Ontario and Alberta Securities Commissions in Canada, is registered as exempt with the Australian Securities & Investment Commission.

This material has been published for professional investors & consultants. All data, unless otherwise stated in the footnote of the relevant page is as at 20 December 2016 and may have changed since. Issued in the UK by Record Currency Management Limited. This material is provided for informational purposes only and is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities, Record Currency Management Ltd products or investment services. There is no guarantee that any of the strategies and techniques will lead to superior investment performance. All beliefs based on statistical observation must be viewed in the context that past performance is no guide to the future. There is no guarantee that the manager will be able to meet return objectives and tracking error targets. Changes in rates of exchange between currencies will cause the value of investments to decrease or increase. Before making a decision to invest, you should satisfy yourself that the product is suitable for you by your own assessment or by seeking professional advice. Your individual facts and circumstances have not been taken into consideration in the production of this document.

Hedging risk warnings

Hedging foreign exchange risk is typically undertaken at periodic rebalance points so that exposures and hedges are rebalanced to reflect the new information. Interim drift between hedged positions will take place because of market movements or because of tactical asset allocation changes in the currency composition of the underlying assets. In addition, hedges are generally rebalanced around certain tolerance levels. These factors will create divergence between the hedge returns and the currency impact on the underlying assets. In addition dealing costs must be taken into account. Further divergence can be caused by proxy hedges where the proxy currency and the underlying currency move relative to one another. Finally, it is generally the case that not all currencies in the portfolio will be hedged or proxied. This is typically the case where there the cost of hedging or the lack of a proxy currency becomes a factor. The nature of hedging means that there will be intermittent cash flows which can be large monetary amounts positive and negative. Actual account set up will depend on each client’s unique requirements to manage cash flows.

Multi-Strategy

The Multi-Strategy product involves passive allocation to strategies during which positions are bought and held. Exposure is maintained to the selections between the periodic rebalancing dates and is not altered due to market factors. The Multi-Strategy product is made up of an allocation to a number of the underlying strategies which may also be invested on a standalone basis.

Emerging Market Strategy

Emerging Market currencies are typically subject to greater country-specific risks than developed market currencies. As a result of this and other factors, Emerging Market currency pairs are typically more volatile than developed market currency pairs. In addition, many (although not all) Emerging Market currencies are invested in through Non-Deliverable Forwards (NDFs), which are cash settled, and the pricing of which is less deterministic than for deliverable forwards. Investment in Emerging Markets tends to be more volatile than more mature markets and the value of your investments could in some circumstances move sharply either up or down. In some circumstances currencies may become illiquid which may constrain the investment manager’s ability to realise the investment. Political risks and adverse economic circumstances are more likely to arise putting the value of your investment at risk.

Where are we in the dollar cycle?

  • The US dollar is at an inflection point. Can the dollar’s cycle continue in the face of convergent economic fundamentals and central bank coordination?

US policy rate normalisation does not guarantee dollar strength – real interest rate support crucial

The US dollar is at an inflection point. On one hand the real exchange rate is yet to comfortably pass its long run average, implying further room for appreciation, while on the other the humdrum chorus of gloomy global economics and a false hopes for US rate normalisation could threaten to pour water on the fire. Indeed, Fed watching has become a favourite pastime for many, presumably in the hope of uncovering clues as to the dollar’s next step, however focusing on the Fed alone is unlikely to uncover the dollar’s secrets. Unfortunately, Fed normalisation cycles alone have never truly been enough to predict a sustained appreciation in the US dollar, and there is no discernible relationship between US rate normalisation, and the nominal or real exchange rate (figure 1). This is natural as currency is and always will be a relative concept.

With this in mind, and given small differences in the level of development between the US and most other developed markets, real interest rate differentials can help us to determine the dollar’s true attractiveness and in turn explain a good deal of behaviour in the medium run (in fact, interest rates and price differentials form the basis for most currency valuation models).  Increasing real interest rates (ceteris paribus, of course) help drive the dollar higher but this effect is more prominent in longer-dated real interest rates than shorted dated. The message one could take is that short term real interest rate normalisation is a necessary but not necessarily sufficient condition for dollar strength, and the US dollar’s destiny may be determined more by elusive long-run forces, in other words natural real interest rates.

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real-rates

Figure 1 and figure 2. Source: Macrobond, J.P. Morgan

Is there scope for real rate divergence?

In view of the theory that US dollar appreciation requires an ascension of US real interest rates relative to the rest of the world, the US dollar cycle may have hit a stumbling block. Declining natural real interest rates have been a global phenomenon (the BIS here and BoE  here have written extensively on this topic), with lower growth, a savings glut and rising inequality as cited culprits. For significant divergence in the long-end of the curve, these fundamentals in the US need to improve. This will be a challenge; even the Federal Reserve has been forced into submission by the secular stagnation thesis as the bank’s long-run projections of interest rates have continued to shift towards that of the market. A similar reality is also evident in the short end of the curve; forward guidance, global economic coordination and increased responsiveness to shocks by central banks are creating fewer economic surprises, fewer opportunities for divergence, and are suppressing interest rate and currency volatility (figure 3).

surprises

Figure 3. Source: Bloomberg, Macrobond, Citi Economic Surprise Index

Can the world cope with a stronger dollar?

While the bar for a stronger dollar would seem high, we believe the US can cope with a stronger dollar, and economic impacts should not hold the cycle back. The US economy is relatively closed with trade making up only 30% of GDP, therefore a stronger dollar is unlikely to pose a large threat to growth via the trade route. Additionally, we should not be too concerned about the currency’s impact on inflation in the US; currency pass-through to inflation is  the lowest among G10 economies (figure 4), in part due to the limited degree of openness but also because the vast majority of US imports are denominated in dollars, limiting the impact on inflation to volume effects only (as foreign imports are diverted elsewhere). 

We think that the rest of the world can too cope with and may indeed benefit from a stronger dollar. Firstly, most developed economies are not troubled by high inflation and would likely welcome a boost in price levels. In particular, the Bank of Japan and European Central Bank are plagued by currency strength and diminishing returns to ever expanding easing programs. In the Emerging Markets, a stronger dollar is not quite what it used to be; most sovereigns have reduced hard currency borrowing significantly, and while in some countries corporates may still be exposed to fx liability risk, EM central banks boast larger foreign currency reserves than in previous hiking cycles, and governors that are more adequately equipped skill-wise to deal with all the economic shocks that a stronger dollar would bring. 

fx-passthrough

Figure 4. Source: “The International Price System” , Gita Gopinath (2015). Eurozone is an average of Italy, France and Germany

Have currency markets become more choppy recently?

  • Are currency markets stuck in a period of short-term mean reversion? If so, what’s driving this and what are the implications for investors?

One straightforward way to look at the level of mean-reversion (‘side-wayness’ as opposed to ‘trendiness’) in an asset over a given period is to look at the so-called Vertical Horizontal Filter (VHF). In essence, this measure computes the difference between the highest and lowest level in the asset price and divides this by how many ‘steps’ it took on the path to get there. The VHF measure was developed in the early 1990s and a low measure would indicate a choppy market, whereas a high measure would indicate a trending phase. In terms of our own preferred definition, mathematically it is : VHF = (Max({Spot in 250 days}) – Min({Spot in 250 days})) / (SUM_{t=2}^{250} (Spot(t) – Spot(t-1))). In other words,  the numerator is the absolute value of the highest close minus the lowest close over the course of a year. The denominator is the sum of the absolute value of the difference between each day’s price and the previous day’s price over this same year.

Below we show the VHF measure for the most liquid currency relationship, namely, the EURUSD cross. The chart shows that we have been in a mean reversion period for most of this year, with effectively this pair trapped in the 1.05 to 1.15 range. Why so? We argue that the Fed backtracking over the trimming of their second rate rise this year has had an impact in dampening further prospects for US Dollar appreciation. At the same time, although the Eurozone has engaged in an expanded QE programme, inflation remains low, and so real interest rate differentials between Europe and the US are not large. The market is now, we believe, pricing in new normal or “neutral” real interest rate (1%) that is much lower than in the past (2%-3%) and this is reflected in flat forward curves in interest rates. This applies to both currency blocks. What do we need for this mean reversion to stop and a new equilibrium to be found? We believe that real rate expectations need to be dislodged from their current static equilibrium and, if so, most currency pairs, including EURUSD will find new equilibrium levels as real interest rate differentials act as drivers of spot rates going forward, something that has been driving Emerging Market currencies of late in fact.

VHF

 

 

Asian “Currency Manipulation” : Mainly a US Concern ?

    • The US has had a long standing concern about what it perceives to be excessive “currency manipulation” on the part of some countries, especially in Asia. This concern is primarily driven by the large and persistent US current account deficit, which will necessitate significant relative currency adjustments for it to at least begin to unwind.
    • A problem with this view emanating from US officialdom is that the pass-through effects between currency movements and domestic inflation in the US has been shown to be weak, thus making the process of adjustment more drawn out at best, and ineffective at worst.

After many years of labelling some countries as de facto currency manipulators in its official statements, US officialdom has now begun to soften its rhetoric in respect of such labelling, especially regarding the Chinese Renminbi. In particular, the US has dropped its oft-repeated description of the Renminbi as “significantly undervalued”, probably in the hope of engaging in constructive negotiations with China (and the BRICs at large for that matter) when the IMF meets in November to decide whether to include the Renminbi as an SDR currency.

While this may be largely diplomatically motivated, the US nonetheless continues to have a material concern about the so-dubbed “currency manipulators” with leading candidates for the US presidency in 2016 sprinkling it in speeches and other fora in present times. We also note that this extends beyond officialdom and into K Street where American auto-makers and leading manufacturers list exchange rate policies across the world, particularly in Asia, as one of their main concerns.

Why this, in a sense, uniquely American pre-occupation with global monetary and currency regimes? After all the European Union conducts a larger volume of trade with China than does the US, for example. Furthermore, the US is a relatively closed economy and largely energy self-sufficient, thus potentially more insulated from FX-induced shocks.

To understand this in more detail, one of the main points to consider is that is that the US (unlike the Eurozone) is running a persistent current account deficit, which means it has more to gain from a rebalancing of the world economy emanating from relative currency adjustments than does the Eurozone. More poignantly, when Eurozone officialdom does make noises about excessive Euro strength, its tends to be about the EURUSD rate itself rather than about the EURCNY rate, for example. This makes sense as the USD is still the anchor of the world’s monetary and financial system, meaning that any Asian country seeking to influence its own currency value will do so against the US Dollar, so there is little point from the European perspective to be concerned about any emerging market currency exchange rate directly rather than through US Dollar lens.

The second point to consider is that the US has long had a manufacturing trade deficit, but especially in automobiles, an industry that tends to be vocal about excessive US Dollar strength. For example, exports of automobile vehicles, parts and engines to Japan amounted to 2.1 USD bn in 2014, whereas imports totalled 49.9 USD bn. While this deficit has narrowed somewhat in the last few years, this automobile trade deficit with Japan alone still represents almost 7% of the entire US trade deficit in goods for 2014.

Third, it is probably still the case that manufacturing blue-collar as opposed to service blue-collar workers still have an outsized impact on US politics relative to Europe. Linked to this is perhaps the reality that the broader benefits of a stronger currency for the general population via lower inflation are less visible in the US than in more open economies, for instance, the UK or Germany. Cheaper imports (the most visible impact of a stronger currency on the consumer surplus) perhaps features less prominently in the US debate than elsewhere.

The fact that the US has a lower currency-cum-inflation pass through has been well documented. Most recently, Harvard economist Gita Gopinath has made the case (convincingly in my view) that the US Dollar’s dominant position in global trade invoicing helps insulate domestic inflation from exchange-rate shocks (see here). As globalisation continues to make consumer markets more integrated and coupled with the rise of technology and price comparison feeds at a global level, it may be the case that the exchange rate–inflation nexus continues to weaken.

This also has significant implications for the potency of monetary policy in the developed world, which may have seen its effectiveness weakened not only by the broken transmission mechanism operating via the bank lending channel post the GFC and Great Recession, but also via this diminished FX-inflation pass through, which continues to be taught and communicated by academic economists and policy makers alike

In all, it would thus appear that from a US policy perspective a stronger USD may be a lose-lose situation, a view I think the Fed (covertly) shares.