A fund manager’s perspective by Campbell Harvey, Benjamin Lesch, Sandy Rattray and Emidio Sciulli.
THE RETURN OF EXCHANGE RATES AS ECONOMIC FUNDAMENTALS DIVERGE
Big exchange rate trends can be a major alpha source for currency managers. In this section, we discuss our view on when they occur, why their absence has recently hurt FX managers and why we believe they will come back.
Trends occur with sustained divergence between economies
Foreign exchange rates reflect the relative economic fundamentals of a pair of countries. When economies are synchronized, there is no need for a structural adjustment, and their exchange rates can be range-bound for considerable periods of time. However, when two countries’ (or regions’) fundamentals diverge significantly over an extended period, the resulting adjustment in their exchange rate often leads to a multi-year trend.
A number of variables characterize these fundamentals: theory points to growth, inflation, real and nominal interest rates, external balances, etc. However, being closely interlinked, these different measures often tell the same story from different angles. This has been documented in research for many years, most notably in a series of IMF papers (see the appendix for references.)
The importance of dollar trends and the US economy as FX moves
Growth divergence has played a major role in the historical movement of the US dollar. Dollar moves in turn are representative of many global currency markets, because of the dominant role of the United States in global financial and trade flows, as well as the dollar’s status as the de facto world reserve currency. Usually, more than half of all variability in exchange rates is related to dollar movements1.
Figure 12 - When US growth diverges from the rest of the world...
...the dollar experiences extended trends
The upper panel in Figure 1 shows real GDP growth (rolling 3-year average) for the US and other major countries. The lower panel shows an index of the US dollar against the currencies of those same countries. The index has had periods of both extended trends (e.g. 1981-1985 or 1995-2001) and multi-year sideways movements (e.g. 1988-1994 and 2010-present).
All the big trends in the dollar index appear to occur as the US economy is diverging from the rest of the world. Examples of this are the remarkable US recovery after the recession in 1981/82 and the ‘Tech boom’ of the late 1990s, which happened against the backdrop of severe financial crises in emerging markets in Asia and Russia. On the other hand, the early 1990s were a period when the US business cycle was broadly in line with the rest of the world.
The range-bound environment over the last few years is not a new phenomenon
The last few years have not been as extraordinary for currencies as they might first seem. Almost all countries have been suffering from a severe slowdown and deep output gaps after the global financial crisis. Massive easing packages have defined monetary policy across the globe. As a result, developed economies have been relatively synchronized and the exchange rates between these markets have been range-bound. Similar periods have been experienced before, and there apperas to be no indication that FX markets have structurally changed.
THE ABSENCE OF BIG TRENDS HAS HURT FX MANAGERS
Historically, most currency managers based their trading (directly or indirectly) on momentum and carry strategies. To illustrate this, Figure 2 shows the Parker currency manager index against simple momentum and carry benchmarks (upper panel) and quarterly returns of the index against a simple 50-50 portfolio of momentum and carry (lower panel). Correlations are very high, close to 80%. Momentum and carry strategies performed positively in the past, but struggled post-2008.
Figure 23: Currency managers have struggled to outperform simple benchmarks...
... and we believe most of their returns can be explained by momentum and carry
WHY WE BELIEVE TRENDS WILL COME BACK
It seems likely to us that economies will diverge again in the future. At the start of 2015, we see indications of considerable economic divergence lying ahead, boding well for extended trends. The US economy appears to be showing robust growth, in stark contrast with continental Europe’s deflationary malaise and Japan’s continued struggles. Exceptional monetary easing is coming to an end in the US, while it is being expanded elsewhere. Furthermore, many emerging markets are facing slowdowns. We believe that it is precisely these divergences that have already led to the strong up-tick in the US dollar in the second half of 2014.
FX ALPHA BEYOND TRENDS
Alternative sources of FX alpha
Apart from the big trends and carry trades, we see that there are a number of other trading styles that offer profitable opportunities in currencies. These have been performing well even as momentum and carry struggled.
Jan 2000 - Dec 2007
Jan 2008 - Jun 2014
A more detailed discussion of these strategies is out of the scope of this paper, but Table 1 shows Sharpe ratios before and after 2008 using simulated returns for these strategies. Trading based on economic fundamentals and technical models5 have made gains in the sideways environment over the last few years. We see that there is no reason why FX managers should have to rely solely on momentum and carry in the future as much as they did in the past: even if the big trends do not come back soon, we believe that there are many other available opportunities.
We believe that a lack of big trends has hurt FX managers’ performance over the last few years. Exchange rates have been relatively range-bound as almost all economies suffered simultaneously in the aftermath of the global financial crisis. However, trends should come back as economies are likely to diverge again. This has already started with the US outperforming the rest of the world. Finally, FX alpha is not limited to big trends, as fundamental and technical models have still made gains in recent years.
FACT BOX: SOME COMMON MISCONCEPTIONS ABOUT FX MARKETS
Besides the lack of trends, a number of other factors have been blamed for the relatively poor performance of FX managers over the last few years. In this fact box, we discuss some misconceptions related to these and why we think they should not be seen as principal problems for FX managers.
“Volatility is lower than ever before and this means there are no trading opportunities anymore”
FX volatility is at unusually low levels now historically, but it has been here before. Figure 3 shows the rolling 2-year volatility of the dollar index. Before 2008, it was not uncommon for volatility to be this low, and it always varied widely. A potential catalyst for increased volatility may be once again the emergence of growth differentials. However, extended trends can be quite smooth and thereby associated with relatively little volatility. This was the case in the early 2000s. In that sense, we see that low volatility has helped predictability and is not necessarily an impediment to performance.
Figure 36: Volatility is low now, but has been similar levels before
“Markets are more correlated than ever before and this hurts alpha via a lack of distinct investment themes”
Asset classes in general (bonds, stocks, commodities, etc.) became more correlated in the aftermath of the financial crisis, but FX markets among themselves are still as much diversified as they were before. Figure 4 shows the average correlations between asset classes and between FX markets.
Figure 47: Correlations in FX are not extremes
It is worth noting here that some periods of high correlations like the early/mid-2000s have actually been positive for FX manager performance: the big dollar trends (which were so beneficial) dominated everything else and therefore came along with increased correlations.
"Because interest rates are ultra-low everywhere, FX carry is permanently damaged."
Interest rate differentials are lower now than they were in the years before 2008, but they have been at similar levels in the 1990s. Figure 5 shows the average absolute rate differential in liquid currency pairs over time. Low risk premia have hurt carry traders over the last few years. However, carry is a long-run strategy and can experience prolonged periods of non-profi tability. We believe that with the low differentials today, the near term opportunities for FX carry are relatively poor compared to the past. This is in line with the conclusions from a study conducted by Norges Bank Investment Management (reference below.)
Figure 58: Interest rate differentials are extremely low now, but have been similar before
- Bacchetta, P., Van Wincoop, E.: ‘On the unstable relationship between exchange rates and macroeconomic fundamentals.’ NBER working paper, 2009
- Engel, C., Mark, N., West, K.:‘Factor Model Forecasts of exchange rates.’ NBER, 2008
- Fratzscher, M., Rime, D., Sarno, L., Zinna, G.: ‘The scapegoat theory of exchange rates.’ Journal of Monetary Economics, 2014
- Hauner, D., Lee, J., Takizawa, H.: ‘In Which Exchange Rate Models Do Forecasters Trust?’ IMF working paper, 2011
- Menkhoff, L., Sarno, L., Schmeling, M., Schrimpf, A.: ‘Currency risk premia and macro fundamentals.’ NBER, 2013
- Nozaki, M.: ‘Do currency fundamentals matter for currency speculators?’ IMF working paper, 2010
- Norges Bank Investment Management: ‘The Currency Carry Trade’ NBIM Discussion Note, 2014
- Ricci, L.A., Milesi-Ferretti, G.M., Lee, J.: ‘Real exchange rates and fundamentals: a cross-country perspective.’ IMF working paper, 2008
- Sarno, L., Valente, G.: ‘Exchange rates and fundamentals: Footloose or evolving relationship?’ CEPR discussion paper, 2008
1. Principal components analysis of currency returns shows that the fi rst component (which is related to the dollar against everything else) has been accounting for 40-70% of the total variability in exchange rates.
2. Source: Man database. Based on Man calculations and subject to change. Countries come into the dataset as they become available over the years. AUD, CAD, DEM/EUR, CHF, GBP, JPY are available from the start in 1977, by 2005 the list includes SGD, NZD, ZAR, NOK, SEK, THB, CZK, HUF, MXN, CHP, INR, PHP, PLN, TWD, COP, KRW, BRL, PEN, INR, RUB, CNH, MYR.
3. Source: Bloomberg (Parker Global Currency Manager Index, Goldman Sachs FX Emerging Markets & G10 3 Month Momentum Index, Goldman Sachs FX G10 & Emerging Markets Carry Index.) 2003 = 100. Man calculations, subject to change.
4. Source: Man database. Man calculations, subject to change.
5. These are short-term, reversion, seasonality effects, cross-asset information.
6. Source: Man database. Man calculations, subject to change. Rolling volatility of weekly returns, 2-year lookback.
7. Source: Man database. Man calculations, subject to change. FX markets: G10 only, as this is available for a long history and avoids distortions to correlations from a varying number of pairs through time. Asset class proxies are Brent Crude, S&P 500, 10-year US Treasury, USD/JPY. Correlations of daily returns, 2-year lookback.
8. Calculated as average of absolute differences in short-term rates across all combinations of 14 liquid currencies (AUD, CAD, EUR, NOK, NZD, CHF, SEK, GBP, JPY, KRW, MXN, BRL, ZAR, USD.) The time-series shown is a rolling median with 1-year lookback. Source: Man Database. Man calculations, subject to change