A full decade of range-bound trade in the dollar has dulled pension investors’ sense of the risks of currency exposure. As Christopher O’Dea reports, all that’s about to change
If something can’t last, it probably won’t. That’s an apt description of today’s currency markets, where the divergence between fundamental economic prospects of the US, euro-zone, Japan and many emerging markets is fuelling a long-delayed return to the volatility that prevailed before the onset of a unique period in which most currencies moved in predictable relationships.
Currency experts say that regime is gone, fallen prey to a trio of fundamental factors that will see the greenback riding high again – including rising US interest rates and improving US economic data. Pension funds that had previously used passive management to protect portfolios against a set portion of their currency risk are increasingly adopting dynamic hedging programmes that adjust their hedges as currency values change, while funds in some regions are conducting a rigorous analysis of their currency exposure – and their hedging options – for the first time.
Many institutional investors have been lulled into a false sense of complacency over the past 5-10 years, says Jeppe Ladekarl, a senior member of the investment team at First Quadrant, where he manages $7.3bn (€5.8bn) in its G10-trading Tactical Currency Allocation strategy. Considering the trade-weighted dollar’s behaviour since the 1970s, the recent decade has been relatively calm, he says. But the wide range of economic performance, and the corresponding array of monetary policies, means pension fund managers need to be prepared for stormier seas.
“We are facing potentially very, very large moves in major currencies,” he says, accompanied by “major differences in national equity market performance.” In that environment, “the trends of subdued movements in currencies are not going to continue.” In the past 5-10 years, says Ladekarl, “it hasn’t mattered what your hedge ratio is – but that’s about to change”. And when it does, he adds, currency effects “can make you or break you”.
Right now the trajectory of US rates is higher, while the trajectory of euro-zone and Japanese rates is lower – reflecting the weakness in those economies and the prospect of further monetary policy easing. That’s a powerful divergence, says James Kwok, head of currency management at Amundi in London.
Two factors are at work, says Kwok. The one making the most headlines is the difference in economic performance between the US and most other countries; disappointing news from Japan, the EU and most emerging markets boosts the dollar. But there’s more going on, he says.
“There’s a much bigger picture going on behind the economic divergence,” says Kwok. “It’s the unwinding of the carry trade – all the investment globally that’s funded by the US dollar. Many emerging markets don’t have enough deposits to fund economic growth, and many corporates borrow the dollar to use in global trade.”
Most countries and corporations had expected US dollar-funding costs would remain low for a very long time, but with the dollar rallying due to economic divergence, and US interest rates set to rise, those funding costs are increasing sharply for non-dollar-based borrowers, potentially leading to contraction of economic activity.
“This is a multi-year scenario, unless the major economies start growing like the US,” says Ladekarl. “I don’t know anybody who thinks the EU is going to turn this thing around and start growing like the US, and it’s the same for Japan. These are structural problems, and you don’t deal with those in a year or 18 months.”
Marc Seidner, head of fixed income at Grantham Mayo Van Otterloo & Co (GMO) in Boston, points to yield curve analysis as a way to assess the next step for the major currencies. “When you compare the three-month Euribor futures curve and the three-month Euroyen Tibor curve, they are almost identical,” he says. “I’m not at all sure that there are many in the market who are picking up on it. I haven’t read that much about the ‘Japanification’ of the euro-zone being priced into bond markets.”
The interest rate picture is fundamental to GMO’s currency view. The message from the bond markets, Seidner says, is that “growth is going to be so slow that it warrants effectively zero interest rates for as far as the eye can see – for the next five years, evidently”. At the same time, the spread between German and US bond yields is historically wide because “you have divergent central bank trends between the Federal Reserve and the ECB”. What does this say to GMO? “The euro should be much lower,” says Seidner. “The last time we were at these levels of interest rate differentials, the euro-dollar rate was in the mid-teens, not 1.28 or 1.29.”
Higher volatility means increased randomness of returns from any unmanaged currency risk in global portfolios, says Lisa Scott-Smith, co-head of portfolio investments at Millennium Global.
“This risk can be mitigated by identifying and managing the foreign exchange risk directly through a hedging or active currency management programme,” she says. The appropriate course of action for institutional investors, in the first instance, depends on the underlying portfolio’s base currency.
Kwok at Amundi says the markets are in the early phase of adjustment, and the initial response is to focus on fundamentals – North American clients are asking Amundi to manage their exposure to the euro, while European institutions which used to hedge passively are now requesting active management of dollar exposures. But euro-based investors aren’t rushing to hedge all their exposures back to the euro.
“If your base currency is being depreciated, and the ECB wants the euro to go down, why hedge your forex exposure back to the euro?” Kwok says. Active management is in demand, he says, because, although the euro is expected to continue to depreciate, it won’t be in a straight line. As a result, simple hedge ratios are being replaced by a more intensive focus on technical factors to manage overlays constructed with options and derivatives. “If the situation changes, you have to adjust,” he says. “How can you explain to your investment committee that you are sticking to one ratio?”
Currency managers are optimistic that enquiries and new mandates will increase in 2015, with recent interest including passive overlay searches by UK public pension funds and corporate cash funds, a large US public fund seeking an overlay manager that has yet to decide between a passive and active approach, and numerous US and Australian public funds reviewing their currency management needs. Middle Eastern funds have also inquired about the effectiveness of implementing overlays on their foreign exposures.
Ladekarl says First Quadrant has been fielding inquiries from Central European and North American pension funds.
“Canadians have been aware of currency risks for a long time,” he says. ‘It’s a commodity economy with large exposure to international investors. In the US context there seems to be a major number – I don’t know why because there’s nothing magic about it – but when US pension funds’ international exposure gets north of 20% of assets, they start to evaluate their currency exposure.”
Ladekarl notes that the critical factor is not necessarily how actively a fund is hedging its currency exposure, but that the decision to hedge or not is based on a tailored plan. While the impact of currency fluctuations will vary from fund to fund, one forex analyst says the dollar’s rise since 2011 trimmed roughly one percentage point annually from the total return of a US institutional investor with a 25% allocation to overseas equities.
Consultants are increasingly raising the matter with fund managers and trustees, Ladekarl adds. Earlier in 2014, CalPERS ceased its passive hedging strategy, saying the performance improvement didn’t justify the cost of the programme, but added that it would adopt a dynamic hedging approach in the asset allocation plan that went into effect in July.
During several decades of investing globally, most US pension plans had low hedging ratios, due to the dollar’s weakening stature for much of that time. “The US dollar seemed to be in a state of permanent decline, but that’s not the case anymore,” says Kwok. “Investors are asking us if the current environment is due to the strength of the dollar or the weakness of the euro,” he adds. “It’s the strength of the dollar.”
For pension investors that means currency hedging “is at the top of the agenda” for the first time in a long while.