What works to produce sustainable returns in currency?
- Published: 08/02/2017
• Strategies for earning sustainable return in currency are more nuanced than in equities or bonds due to the absence of a “long-only” beta
• We argue that there are, however, strategies to target sustainable returns in the currency space
• This blog post describes growth, carry, momentum and value as potential sources of return in currency
How do investors sustainably make returns in the currency space? Clearly, this is more complicated than in equities or bonds- there is no “long-only” beta in currency. Nevertheless, there are sustainable sources of return in currency which can make returns over time, which we summarise in this blog post:
Economies which see faster productivity gains find their exchange rates appreciate in real terms. An investor which takes a long position in faster growing economies, funded by a short position in more slowly-growing economies, can expect to pick up this appreciation on average.
This relationship between growth and currency appreciation is referred to as the Balassa-Samuelson effect: exchange rates vary according to productivity because of the existence of a non-tradable sector. As economies become more productive, increases in productivity in the tradable goods sector lead to wage increases which filter into the non-tradable sector raising prices and wages. The resulting price rises cannot be arbitraged out by the exchange rate, and this expresses itself as a real exchange rate appreciation (see Figure 1).
This effect is particularly prominent in Emerging Market (EM) economies. Productivity growth is related to GDP per capita through the Convergence Hypothesis. This states that poorer economies grow more quickly to “catch-up” with richer economics. Consequently, EMs tend to see real appreciation against Developed Market (DM) economies.
The currency carry trade takes a long position in higher interest rate currencies, funded by a short position in lower interest rate currencies. On average, currency spot movements are insufficient to cancel out the raw interest rate differential, which is the source of the returns to the carry strategy.
Why does the carry trade make money, and why are its returns not simply arbitraged out? Similar to the commodities carry trade, the currency carry returns reflect a risk premium. The reason that high interest rate economies offer high real interest rates is that they are riskier economies to lend to, and must compensate investors for this. In DM economies, countries with persistent current account deficits must find a way to fund these, and typically this funding comes at a price (see Figure 2). Norway is an outlier because its large sovereign wealth fund “sterilises” current account surpluses by keeping them offshore. In EM economies, higher real interest rates additionally reflect perceived inflation risk and policy credibility.
Hence, the currency carry trade consists in taking on the risk of lending to certain economies. Investors will not take this risk on for nothing: in return, they demand a risk premium.
Currency movements are not a random walk: there is information in today’s price that helps predict future price evolution. Currencies tend to “mean-revert in the very long-term or short-term but over a 3 to 12 month horizon, certain currency pairs tend to exhibit momentum or “trending”. Statistically, the existence of currency trends can be defined using “volatility bars”, which show annualised volatility calculated across different time horizons. In a data-generating process where there are no autoregressive or mean-reverting elements, the variance does not depend on the time horizon (and hence the volatility of the associated time series should be similar regardless of the horizon at which it is measured). By contrast, in a trending time series the variance increases as the time horizon increases. Intuitively, volatility at the near end of a trend should be lower than in the trend taken as a whole.
Figure 3 shows that this applies to six major currency pairs, and on average in the G10 currency universe. The USDCAD pair is an exception, (where we argue that momentum is likely rapidly arbitraged because of geographical links) as is the AUDUSD pair.
Why do currencies exhibit momentum? Firstly, information may filter through to market participants at different time horizons, so that the market reacts in a staggered fashion to new information. Secondly, herding behaviour (trend-following strategies) may themselves generate momentum in currencies, as market participants exacerbate trends by buying into them. Thirdly, delta hedging of options may lead to tending behaviour. As the price of the underlying currency rises (falls) the delta of call (put) options rises, so entities short options must increase underlying long (short) positions in order to delta hedge. This introduces structural reasons why currencies trend.
An investor who can identify and exploit these trends will find this a key potential source of return.
Currencies tend to be mean-reverting at longer time horizons. Economists use the concept of a currency’s “fair value” to describe equilibrium values to which currencies return over the long-run. An investor who can correctly identify deviations from these equilibrium values and take a position reflecting convergence back to fair value will make a medium-run return.
One simple valuation method is the well-known concept of Purchasing Power Parity (PPP) can be used. PPP is the implied exchange rate that equilibrates the price of a specified basket of goods in two countries assuming each has their own exchange rate. The theory underpinning the use of PPP as a fair value is the “law of one price”. This states that over the long term, sustained deviations from PPP cannot persist, because they would be arbitraged out (consumers would see an opportunity to purchase goods only in the cheaper currency).
There are sustained deviations from PPP due to the Balassa-Samuelson effect (see Figure 1).In the G10 universe, GDP per capita is sufficiently similar that PPP works as a valuation measure. Those wishing to trade value in the EM universe may need a more complex valuation methodology.
Naturally, optimal currency investing requires a sensible combination of these strategies, as well as nuanced implementation and effective risk management. While not exhaustive, however, these strategies provide a basis for how investors can think intelligently about how to target returns in the currency space.