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Currencies in the current economic climate

Thursday, May 19, 2016

Currencies in the current economic climate

Currencies play an increasingly important role in investment markets with the potential to hugely impact portfolio returns on both the up or downside. This is the case given the effect that exchange rate movements have on businesses through revenue streams or costs as well as assets and liabilities denominated in different currencies. 

This has explicitly been the case since the 18% appreciation of the US dollar since mid-2014, which resulted in many investors wanting to bring currency risk management to the forefront of the asset management industry. This is even more necessary as the size of the currency market, through a widespread adoption of global benchmarks, foreign infrastructure and/or alternative asset classes, is becoming increasingly bigger, which will mean investors need to have greater awareness of current currency issues.  

The currency movements are becoming more important in themselves, especially considering the tendency of major central banks to use monetary policy, implicating the currency market, as a means of curbing inflation and promoting growth. This gives way for currencies to display long-term trending movements as well as resulting in increased daily volatility, the most obvious example being the sharp strengthening of the Swiss franc on 15th January 2015.

Over this and the past year we have seen much surprise on the currency front with regards to China, US, Europe and a number of emerging market economies. We are, without a doubt, sure to see more surprises throughout the year on a number of major currencies because of their susceptibility to all the politics taking place alongside central bankers’ mixed messages. 

This all means there are a number of concerns to consider in the currency market including, but not limited to, the Chinese renminbi’s continued volatility amid fears of a substantial devaluation, the position of the Japanese Yen on the back of negative rates and an upcoming election, a potential return of a currency wars, the strength of the dollar in the aftermath of the US presidential elections and the Fed’s hiking cycle and last but not least, the outcome of Britain’s EU referendum and its impact on the pound and euro. 

Clearly it’ll be an eventful second half of the year and given the significance of currencies on investors’ portfolios, we spoke to a number of asset managers to get their current views on major currencies and their associated impacts to investment markets. The individuals we spoke to were Daniel Loughney, Fixed Income Portfolio Manager at AllianceBernstein, Adrian Owens, Investment Director and Manager of GAM Star Discretionary FX, Ugo Lancioni, Head of Currency Management at Neuberger Berman, Record Management and James Binny, Managing Director, Head of Currency EMEA at State Street.

Our Panel
Daniel Loughney, Fixed Income Portfolio Manager at Alliance Bernstein
Adrian Owens, Investment Director and Manager of GAM Star Discretionary FX 
Ugo Lancioni, Head of Currency Management, Neuberger Berman
James Wood-Collins, Chief Executive Officer at Record Currency Management
James Binny, Managing Director, Head of Currency EMEA at State Street

Where do you expect the US dollar to go and how will this affect investment markets?

Daniel: Over the near term we see the US dollar weaken versus the euro as the Fed dilutes further its hawkish rhetoric. We see it strengthen against the pound on Brexit while it will likely keep pace with the Yen ahead of the Japanese elections.

James WC: As a predominantly systematic manager, we avoid the temptation of making forecasts in developed currency markets, in particular ones as widely followed as the US dollar – to have a better view on US dollar exchange rates than the market, we would need to understand ideally both the US economy and that of the other currency better than the market as a whole, and for the market then to catch up with our understanding.

What we do think about is the distribution of potential outcomes – so for example if the Federal Reserve surprises the market with more interest rate rises more quickly, we would expect the US dollar to appreciate further.  This will be good news for overseas holders of US assets such as US equities and Treasuries, but will prove costly for US investors holding non-US equities.  Since the US equity market is the world’s largest, and US Treasuries one of the world’s “safe haven” assets, any effects will be widely-felt.

Adrian: US economic data have been surprising to the upside and underlying inflation has been drifting higher. At the margin we think that investors may have over reacted to Ms Yellen’s recent rhetoric and as long as the economy continues to move forward, front end rates will respond. Given the underlying improvements in the US economy the risks, to us, are very much skewed towards more tightening. If correct this should also put a floor under the US dollar. We are sympathetic to the reasons why the Fed does not want too strong a dollar. Two years ago a strong dollar was part of the solution as the global economy needed to rebalance. Today too strong a dollar has become a problem as it creates issues for commodity markets, emerging markets and, in turn, risk more generally. We see the dollar as broadly range bound over the next few months with an upside bias as the US economy continues to recovery and given the limited amount of rate hikes currently priced by markets.

Ugo: Our analysis suggests that a period of consolidation is likely.  Over the next 12 months we do not expect currency markets to exhibit a strong trending behaviour such as the one we saw in the USD in 2014/15. We anticipate the US dollar to trade in a range as the Federal Reserve is still assessing the indirect tightening impact of a stronger currency. However, the range is likely to be wide enough to attract investors’ interest at the extremes of the range.  Following the recent move in the US dollar lower, we have re-built a small overweight exposure in portfolios. In our view, as the economy approaches the Non-Accelerating Inflation Rate of Unemployment, continued strength in the labour market will start to feed into wage pressure which would likely trigger a re-pricing of the rate path. Furthermore, many of the downside risks to the Fed’s economic outlook have continued to dissipate. 

James B: The dollar has been widely expected to rise further as US Federal Reserve is expected to be the first major central bank to raise rates.   This story was successful during 2014 and 2015, but has retraced somewhat in 2016, to an extent caused by the expectation of rate rises being delayed.  Although not obviously undervalued we suspect that ultimately, as increases in US interest rates become priced in again, the US dollar will resume its strengthening trend but with a slower trajectory.  

What are your expectations of central bank policies this year to control currencies?

James B: The last few years has seen much discussion as whether central banks were competing to devalue their currencies, resulting in “currency wars”. However, there was suspicion that central banks came to some kind of understanding at the G20 in Shanghai in February 2016 to pullback from such behaviour. There is no suggestion that a formal agreement was reached, but perhaps a realisation that such behaviour could be dangerous and destabilizing, with the volatility at the start of the year acting as a catalyst for such concerns.  

Certainly since then central banks seem more coordinated and less inclined to push their currencies down. The BoJ (Bank of Japan) , for example, has refrained from intervention, despite yen strength (so far); while the ECB did cut in March, Mario Draghi said that he did not expect to cut further which caused the initial euro fall to reverse.  The Fed has also been more dovish (decreasing the policy divergence story), allowing EM currencies to rise from levels which were causing strains, particularly with respect to servicing of external debt. Also, devaluation of the Chinese renminbi at the end of last year/start of 2016 has partially been reversed.

Adrian: A number of central banks have been relatively inactive over the last few months. The ECB, the Fed and a number of smaller Central Banks (including the Swedish Riksbank, the RBNZ and the central bank of Brazil) have all left rates unchanged. Although the US Fed omitted previous language that “global economic and financial developments continue to pose risks” the most recent statement was seen as broadly neutral and more dovish than it might have been. 
However, this period of inaction is likely to be tested as the data evolve over the coming months. This may well call into question the credibility of central banks inaction. Fundamentally, we expect continued modest data improvements over the coming months. Recent data releases in the euro area point to GDP growth of around 2%, the labour market is strengthening and credit growth has been solid. Latest activity data (both the Markit and NBS PMIs) have also been encouraging in China. 

Daniel: Central banks will continue to use their currencies as tools for economic management. However, the deteriorating global growth environment means that they are all trying to do similar things to their currencies which will result in heightened FX volatility.

James WC: We see relatively little action by developed market central banks with the explicit intention of controlling currencies, other than in those currencies that are explicitly “pegged”, such as the Danish krone to the euro, or the Hong Kong dollar to the US dollar.  Within emerging markets, such arrangements are more common as exemplified by the Chinese authorities managing the renminbi against a basket, but even these are reasonably well-disclosed.

What is more common though is for central banks to take action with the explicit intention of managing the domestic money supply, and which causes a side-effect – welcome or otherwise – on currency markets.  What’s fascinating about this year is that the side-effects we have come to expect – e.g. further currency weakening following the introduction of negative interest rates and further easing measures, as in Japan and the Eurozone – appear to have become much more muted, as evidenced by both the yen and the euro strengthening against the dollar in the first quarter of 2016.

Ugo: The poor global backdrop means that investors are more sensitive to exogenous sources of risk. The heightened sensitivity to external factors was evidenced by the rapid and violent wave of risk aversion experienced at the beginning of the year. A high sensitivity to external factors means that overall market sentiment becomes a more important explanatory variable of the movement in currency prices. Idiosyncratic factors and domestic fundamental dynamics have at times played a smaller role as a result. An increased sensitivity of currencies to overall market sentiment reduces the efficacy of central banks in controlling their currency.

Moreover, in a low growth, low inflation environment, currency movements matter more at the margin. Over the past few years we have been used to central bank policy makers expressing their concern over the strength of their currencies. However, most recently there has been a concerted effort to avoid directly targeting currency devaluations at the expense of other countries. In reality until inflation and growth pick up sufficiently, central banks will be tempted to use their currency as a policy tool. Their ability to achieve their objectives without resorting to currency depreciation in the current market environment remains questionable.

How do you believe the Japanese Yen will be affected following the BoJ’s decision to move interest rates into negative territory?

James WC: So far the Japanese yen’s response to January’s decision has been counter-intuitive – the yen has strengthened rather than weakened, at least against the US dollar.  This can be attributed more to declining expectations of further dollar rate rises than to any specific yen decisions, and it is a timely reminder that currency factors are always relative, compared to the other currency in any given pair, rather than absolute.

Daniel: The Yen has actually appreciated since NIRP as asset allocation flows and risk aversion sentiment have dominated. The BoJ are pressured by the people on NIRP and by big business on Japanese yen appreciation. They are finding it difficult to manage but ahead of the elections they will strive to keep the Yen steady.

James B: The Japanese yen has behaved in an inconsistent manner with respect to interest rates.  In January when the BoJ moved to negative rates, the yen strengthened, after initial weakness; then when the BoJ did not cut rates further in April, the currency also strengthened. Arguably the currency has shown its undervaluation to be more important than changes interest rates through this period.

Ugo: Wider interest rates differentials between Japan and other countries make the hedging cost back into yen more expensive and provide an incentive for Japanese investors to pick up yield by investing abroad. The move to negative rates introduced by the BoJ in January failed to trigger a yen depreciation, as it coincided with a period of risk aversion and the yen remains one of the best hedges against risk aversion. 

BoJ has stepped up its intervention rhetoric after the yen appreciated 10% against the USD since the beginning of the year. However, probability of official intervention is very slim at these levels and it is only conceivable in the event of a very sharp appreciation of the currency.  Intervention would be unwelcome by G10 countries and could risk triggering a further devaluation from China. 

However, In our assessment the yen is still undervalued when measured in real terms against a basket of other major currencies

What are your views on the euro given a possible Brexit on the horizon?

Daniel: In one way this should be bad for the euro and so if Brexit occurs in an environment of improving global growth then the euro will likely weaken. However, if global growth momentum deteriorates further then the euro could be supported by risk aversion flows.

James WC: Market reaction to the EU referendum scheduled for 23rd June has so far been more evident in sterling exchange rates – sterling broadly weakened following the referendum’s announcement, implied volatility in options pricing has risen particularly as the referendum date has come within the maturity horizon, and the price for protecting against sterling weakening has risen more than that for it strengthening.

These effects have been less pronounced in euro exchange rates, with a mixed picture on spot exchange rates and modest changes in volatility, although some increase in the cost of protecting against euro weakness can be seen.  This would be consistent with the market regarding a UK vote to leave as a bigger issue for sterling than for euro, although as ever we would be cautious about attributing market movements to a single issue.

Ugo: Brexit is a binary event. Our view, which is broadly in-line with the probability implied by bookmakers’ odds, is that Britain voting to leave the EU is unlikely to happen. More than just a UK story, Brexit would potentially have severe implications for the Eurozone. At a time when policy makers are struggling with a humanitarian crisis alongside the economic crisis, and with a resurgence in support for populist parties who promote sovereignty and national isolation, Britain leaving the EU could well provide the catalyst necessary for other countries to begin discussions on their membership of the EU and/or demands for special allowances similar in style to those that David Cameron claims to have secured. 

Currently, much of the Brexit risk premium has been focussed in sterling. Most notably, the demand for protection has increased dramatically as can be seen by the implied volatility in option markets. However, should Brexit happen, we expect focus to turn to the single currency. As questions are raised over the strength of the economic union we would expect higher volatility in the single currency.

James B: The euro has generally strengthened more than many investors expected in recent months.  Partially this is due to the significant current account surplus. However, it is also likely due to reserve managers, who have become increasingly influential in currency markets, reallocating from US assets, where they were overweight, to European assets, where they were more underweight. However, should the UK vote for Brexit it is likely to have a directly negative impact on the European economy as well as introducing other uncertainties in many European countries, where other anti-EU political parties are strong resulting in calls for their own referenda. It is likely that such factors would lead to a fall in the euro.

Adrian: Within the UK we have used dual digital options as a low cost way of seeking some protection from a possible UK vote to leave the EU. The structures would benefit from sterling weakening against the euro after a vote to exit but to pay out would also require euro/ USD to fall (the view being that a UK exit weakens the euro project). Such structures avoid the costs of simply buying options outright.



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