It’s a war out there
Anthony Harrington finds optimism among active currency managers, and that a top-down discretionary approach might be best-suited to surviving and thriving through the ‘currency wars’
Those who argue that institutional investors should re-think their attitude to active currency management point out that returns to global bond mandates have been pretty much equal to returns to global currency over the past 10-15 years. One of those markets is about to run into a world of trouble, the argument goes – and it isn’t going to be FX.
“The point is that fixed-income investing is coming to the end of a long bull run,” says Clive Davidson, head of currencies at Schroders. “So people who invested in global bond funds and found themselves profiting from the FX differential in their favour can use our basket-of-currencies product to continue protecting the value of their investment. It has appeal to people who realise the benefits of a diversified global bond fund, in that they can switch to a diversified currency fund without the duration risk that the bond funds take.”
George Saravelos, FX strategist at Deutsche Bank, agrees but thinks that investors are not quite getting it yet. “There is definitely a trend towards diversifying on the part of the institutions and FX is benefitting from this, but by no means as much as, say, commodities or real estate,” he says. “The last few years have not been good for currency returns – but we are entering a bull market for currencies.”
But that is really the question. Why hasn’t active currency profited from recent conditions, and if these conditions persist, how is it adapting to do so? Currency traders are having a wild ride at present, with the race to the bottom of the so-called ‘currency wars’ creating plenty of volatility and momentum. However, when currency pairs keep flip flopping as this or that political shock ripples through the global FX markets, currency funds looking to create alpha for their clients often get hammered, finding themselves caught on the wrong side of the trade.
“Over the long run, all three of the major strategies for generating alpha in FX – namely, carry, momentum and value, have had their moments in the sun, and all three have had their failures,” says Davidson. Schroder’s response to this has been to try to ‘mix and match’.
“Our style is top-down and bottom-up with respect to world economies, where we focus on a spectrum of some 30 countries,” he explains. “We’ll do detailed research on each country – that’s the bottom-up bit – and the top-down part comes from blending global themes into the mix, focusing on the biggest economies of the US, China, Japan and the euro-zone.”
An example of a top-down approach would be to take the weakness of sterling as a symptom of the weakness of the UK economy viewed against other major advanced economies.
“This is not really a carry or a momentum play, so you would probably characterise it as more of a value process,” he says. Schroders cross references this top-down value view with quant models that look to pick out any imbalances in some five or six macro factors, such as imbalances in current accounts, credit growth, FX exposure at the country level and loan growth before applying chart analysis that is largely about trying to capture any momentum, and sentiment analysis.
“But you have to bear in mind that when we trade FX we are looking at ideas that might take months to come to fruition,” he says. “We don’t try to spin the portfolio on the next 20 pips of movement, the way a hedge fund might. And while we are trying to generate alpha we make sure that we do not have any overly centralised FX exposure in just one currency pair. If you have a strong view you want enough flexibility so that you can make some money and express the view, but you also want to encourage diversification.”
Thomas Stolper, chief currency strategist with Goldman Sachs, reckons that the euro crisis was very navigable by FX traders who took the time and trouble to develop a deep understanding of the various political currents driving the process.
“The correlations between currency pairs were rock solid. If you had a good idea of what the next headline was going to be, you knew what the FX market was going to do,” he says.
That said, Stolper admits to a certain frustration in his efforts to capture sterling’s recent moves.
“I had a long-standing view that sterling had to weaken,” he explains. “We shorted it twice last year but got stopped out on each occasion, which annoyed me a lot. However, we fully caught the euro move up and down so that was satisfying.”
Currency markets might look chaotic but they often respond to very clear macro pressures – and where they don’t, they tend to correct fast in the direction of those pressures. Stolper reckons that the yen could well be a case in point. “The weakening of the yen has gone too far, too fast,” he judges.
Tellingly, there has been very little participation by Japanese investors in this move. It has all been driven by very high expectations from non-Japanese investors anticipating very sharp increases in quantitative easing by the Bank of Japan, for example. Hedge funds have piled in and made the move down very sharp, but this neglects the fact that Japan has remained in a better balance-of-payments position than the US.
“From a pure capital-account perspective you would argue that, in reality, the Japanese yen should be stronger than the dollar,” Stolper says.
The move in interest-rate differentials is far too slight to justify the move in the spot price, so a big chunk of the yen’s movement could get reversed; these are the kinds of things that an active currency management regime looks for and when they pay off, they can generate serious alpha. The big story to watch, Stolper says, is whether Japanese investors with big overseas bond portfolios decide to hedge these back into yen or not.
“These investors have been extremely low-hedged up to the last few years and have been assuming all the currency risk that came with bond portfolios,” he observes. “This was because the cost of carry was very high. When you are hedged you paid overseas interest rates and earned very low Japanese rates, which made hedging fiercely expensive. Then the US slashed interest rates to near zero and the Japanese could buy their own currency on a forward basis, which they did in spades. Do they want to change this position? I don’t think so.”
The problem with predicting how the Japanese investor will finally jump is that Japan is in a unique position. The demographics are exceptional with no precedent for traders to draw on.
“It does not look like a no-brainer that the yen will weaken forever, so my preference would be to fade a bit of the change down,” says Stolper. “But what this shows is that FX funds definitely have to do a lot more work under present market conditions to plot their course.
Until last year, all you had to do was guess the next move in the European sovereign debt saga and you could pretty much foresee what was going to unfold in the FX market generally. Now there are a lot of country-specific stories with a lot of moving parts. However, in my view, this is very much when currencies are extremely well placed to deliver alpha.”
That said, Stolper is not expecting to see any major dash into FX by institutional funds. It will be very performance-driven, he suggests, and in his view the best performance in the current environment is likely to come from macro-focused FX funds.
“A lot of the FX funds out there are very technical, model-driven, super-sophisticated funds with not much macro content to them at all,” he notes. “Some may struggle to adjust to the complexities of a policy-driven and macro-driven market. For example, how do you back test the yen’s response to ageing demographics? Something similar has never been observed before. So there is scope for outperformance for FX funds with a specific macro angle. The technical funds might be able to capture some of this as well, but it is very macro favourable.”