Chevron icon It indicates an expandable section or menu, or sometimes previous / next navigation options. HOMEPAGE

Here's how to protect yourself from the currency wars

Markets, economies and political dynamics are always in flux. That’s a big reason why understanding what trends have staying power — knowing how the environment of today differs from that of the past — is crucial to intelligent, informed investing.

Advertisement

One undeniable source of divergence from the past is the recently heightened currency volatility. Currency volatility can wipe out gains from investments in other assets and create a sense of uncertainty over returns. Taking a different perspective on the dynamics behind currency volatility can help institutions appropriately hedge the risk in their portfolios and generate alpha.

us army sniper
An Army sniper takes aim. US Army Capt. John Farmer

In 2013 currency volatility began to rise as the taper tantrum — the market turbulence that followed the Federal Reserve’s mere intimation that it would wind down its bond buying — took effect. Rising U.S. interest rates forced a sharp move in global rates and led to a substantial pullback in capital from emerging markets.

The more interest rates move, the more the attractiveness of one currency versus another changes. More recently, another dynamic has emerged: Currency volatility and interest rate volatility in the U.S. are diverging (see chart 1).

USD vol
Institutional Investor

In the developed world, central banks have increasingly used currencies as a lever to stimulate their domestic economies, because these countries are reaching the end of their debt supercycles and are unable or unwilling to use traditional interest rate channels to support spending. Historically, to spur economic expansion, central banks would cut interest rates to facilitate credit creation. The increase in borrowing would invigorate the economy and push growth above trend. With high debt levels across the developed world and interest rates at their lower bound, however, this maneuver is no longer possible.

Advertisement

Though each developed-market country’s story is slightly different, all suffer from the same problem: a diminishing ability to stimulate economic growth and offset deflation. Japan has been experiencing deflationary stagnation for the past 15 years. The euro zone is dangerously close to the same fate. The next big move for Australia and Canada is likely down, as their household sectors have not yet deleveraged and their commodities sectors have trailed off. All developed markets either need or will soon need economic stimulation, though interest rate policy will likely have very little direct impact.

Currency depreciation works through four channels that are different from those of interest rate–based stimulus — none of which require a pickup in debt. First, a falling currency has the immediate effect of boosting corporate profits through margin expansion. To the extent that a corporation pays costs such as labor and capital expenditures in local currency but earns revenue in a foreign currency, margins immediately expand on the back of currency depreciation. Such a phenomenon contributed to corporate profits in Japan soaring when the yen fell after the introduction of quantitative easing in 2013.

Read the original article on Institutional Investor. Copyright 2016.
Advertisement
Close icon Two crossed lines that form an 'X'. It indicates a way to close an interaction, or dismiss a notification.

Jump to

  1. Main content
  2. Search
  3. Account