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Political Volatility In Play In Currency Land

By: Paul Lambert & Mark Pursey

Ten years ago, there was great optimism for the future. We thought we would all retire early, that new technology would make us rich, and that the markets would forever rise.

Now, at the beginning of the 21st century, the west faces aging populations, single- digit growth, and volatile markets, making traditional, benchmark-hugging investment solutions incapable of providing the returns we need to make possible that dream of an early and wealthy retirement. At this time of great uncertainty for the global economy, one market, currency, is moving centre stage.

The bursting of the U.S. economic bubble and the associated end of the bull market in equities has left policy makers around the globe grappling with internal and external economic imbalances. The U.S. consumer boom of the 1990s was largely fed by imports from Asia, resulting in the U.S. recording a record current account deficit as a percentage of GDP.

Now China and Japan are running current account surpluses with the U.S. History suggests that such imbalances cannot be sustained forever. A move back to balance typically involves either a relative rebalancing of domestic demand and/or a currency adjustment. In an election year, the U.S. seems to have signalled through record interest rate cuts and fiscal policy stimulus that they would do everything they could to avoid allowing adjustment through a weaker U.S. economy.

The last G7 meeting in Dubai was special. Not since September 2000 when the G7 agreed to support the flagging Euro has currency featured so prominently in the final communiqué. The pressure applied to Asia by the U.S. administration coupled with their domestic policy choices has reinforced the notion that the U.S. would prefer to see adjustment of the external imbalances brought about through adjustment of the currency, at least for now.

At the same time, faced with a world where benchmark returns from traditional asset classes are expected to be lower, but where liabilities continue to rise, there has been a focus on a search for alpha. With currency back on the front page due to global imbalances, people have taken a closer look at the attributes of currency as a potential source of alpha. Already traditional and specialist money managers – from equities to hedge funds – have realized that in order to match liabilities, they need to seek alpha. There is good evidence that currency managers have long been achieving high risk-adjusted returns in comparison to managers of other asset classes.

In many ways this should not come as a surprise. Creating alpha relies on the existence of recurring market inefficiencies and currency management skill in exploiting them. The currency market is particularly rich in inefficiencies as most of the players are motivated not by profit, but by other agendas. For example, policy makers with political and monetary agendas may temporarily move markets away from fair value. Separately corporate treasurers participate in the currency market to fund balance sheet, budgeting, and cash flow needs, with bottom-up international equity managers only considering currency as a third order decision after stock selection and country allocation.

Zero-sum Game

Creating alpha through currency is a zero-sum game. For every winner, there is a loser. If a fund manager is creating alpha, someone else is losing alpha. As discussed above, fortunately, for the currency manager, systematic losers remain in their investment space. The plan sponsor’s job is to choose the ‘winning side’ and the markets in which the fund manager is more likely to be winner. Otherwise, they can step out of the game, accept what the market has to offer, and adopt a long-term buy and hold strategy.

Clients of money managers, however, have diverse applications of currency alpha. In addition to overlays in international exposures and cash enhancement.

Some have found innovative ways to do this. One charitable organization, whose main income is derived from donations in U.S. dollars, each year creates an annual budget to meet its $600 million payments to 147 countries across the world. The client’s challenge was that if the U.S. dollar falls in value against other currencies, it would not have reserved enough to meet its payment targets. A high percentage of the payments it makes are to projects in developing countries, whose currencies can be volatile against the US dollar.

Its manager created a foreign exchange strategy that could manage the client’s exposure to currencies of developing countries. This manager’s currency team was able to meet the specific exposures of the organization’s liabilities.

As the client had arranged for a thirdparty prime broker to consolidate the counterparty risk, it did not need to physically fund the account with cash and instead could use currency forwards which are not exchange-traded.

Having decided to seek currency returns, the next decision is to determine how much active risk to allocate to the mandate. As with any alpha source, this decision should be proportional to an investor’s confidence in the strategy and how well it complements other sources of alpha and beta in the total scheme.

Annual Loss Limit

In the case of the charitable organization, it understood only too well the risks of engaging in developing countries, and, for that reason, required an annual loss limit to be built into its strategy.

As investors develop a better understanding of these issues, fund managers are seeing more and more pensions structuring themselves into a benchmark-oriented beta-fund as well as an alpha fund. The beta fund has market exposure to stocks and bonds (usually trying to match long-term liabilities) and the alpha fund is a collection of benchmark-free strategies (structured with an eye toward making money in any environment). With the end of the bull market, more and more investors are reducing market exposure and adding alpha exposure.

When creating alpha in currency space, you are inevitably long in one currency and short another. In this long/short portfolio, not only does the manager buy the assets he or she favours, but also sells the assets they find expensive. Unlike in the equity or bond market where everyone can lose together, in the currency market there is always a winner on the other side of a loser’s trade. As a result, the correlation of currency returns with other asset classes tends to be relatively low. It should be noted also that currency investors transact in the world’s largest market measured by daily turnover. The result of this is that transaction costs are relatively low.

What, however, is out of the hands of currency investors and managers is where opportunities will present themselves. For this reason, it is sensible to spread your net of expertise as widely as possible in the currency market. Taking such a broad approach improves your possibility of finding compelling trading opportunities.

The last three years have been very disturbing times for investors and managers alike. What is certain is that in the current investment climate there is no better time to be engaged in currency strategies to create alpha. H

owever, as we grow used to this new investment regime we must realize that while risk and engagement in the creation of alpha may suit increasing numbers of investors, beta and bull markets are what win politicians elections.


Paul Lambert is with the currency overlay team and Mark Pursey is head of corporate communications at Deutsche Asset Management.

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