Currencies have become an asset class in their own right as investors explore attractive alternatives to traditional asset classes. The low correlation of currencies with equities and bonds makes them an interesting addition to a well-diversified portfolio. In the interview below, portfolio manager Thomas Kressin gives an overview of the global foreign exchange (FX) markets and ways to invest in currencies.
Q: Amidst uncertainty about the direction of global interest rates, currency markets are making headlines. “Carry trades” have been cited as a main culprit for some of the turbulence in global financial markets. What are carry trades and how do they influence financial markets?
Kressin: In a carry trade, an investor borrows in a lower yielding currency, such as the Japanese yen or Swiss franc. The borrowed money is then invested in a higher yielding currency – like the U.S., Australian or New Zealand dollar – thus creating upward pressure on these currencies while resulting in downward pressure on the financing currency. These trades have become very popular in recent years mainly for two reasons. First, these trades provide a substantial yield pick-up, stemming from the different interest rate levels in the countries where money is borrowed and invested. Second, relatively low exchange rate volatilities have reduced the likelihood of setbacks for investors.
As investors have become more risk-averse in recent weeks due to the turmoil in the credit markets, they have reduced these carry trades or even reversed them, especially versus the yen. This caused the yen to appreciate against most other currencies. The unwinding of carry trades may have come as a relief to central banks around the world, whose currencies climbed to worrying heights. For example, due to the appreciation of the New Zealand dollar, that country’s central bank conducted its first ever currency intervention this summer (after a longer period without major currency market interventions around the world).
Q: Is the carry trade a new concept?
Kressin: The carry trade has been described for quite some time in finance literature as an empirical inefficiency and is also referred to as the “Forward Rate Bias.” The inefficiency occurs because a lower yielding currency doesn’t appreciate against the higher yielding currency as much as implied by the forward rates. Under rules of arbitrage, if the currency appreciated as it theoretically should, reflecting interest rate differentials, investments in currencies wouldn’t generate any excess returns.
The yen/Australian dollar exchange rate provides a good example to illustrate this point. According to theory, the average monthly realised returns from the difference between the current rate and the forward rate should be zero. Empirical evidence shows though that an investor could have made a monthly return of around 0.3% on average from borrowing in yen and investing in Australian dollars over a period of 15 years. The market, of course, looks for such inefficiencies and takes advantage of them.
Q: Currencies in general – and not only carry trades – have become en vogue with investors. What drives this wider interest?
Kressin: The recent increase of interest in currencies is largely related to the low yields available in many global fixed income markets. Low yields make currencies an attractive asset class for two reasons. The first reason is diversification because currency investments are largely uncorrelated to the traditional asset classes – equities and bonds.
Currencies also have a relatively low correlation to systemic risks inherent in the market, unlike some alternative investments such as hedge funds, which may possess a high correlation to systemic risks.
Q: Many investors already have diversified portfolios. Why should they consider adding currencies?
Kressin: As mentioned above, currency returns are generally uncorrelated with other asset classes like equities or bonds. With a systematic and well-diversified approach like PIMCO’s, an additional allocation to currencies allows an investor to improve the risk/return profile of the existing portfolio.
Q: What role do currencies play in investors’ portfolios?
Kressin: Looking back we can identify three major roles that currencies have played. Currency trading began as an effort to hedge currency risk. Later, investors began to trade currencies more actively in an attempt to enhance returns on foreign investments. Today, investors increasingly view the currency market as an alternative asset class of its own.
The reason for this transition in the role of currencies is that investors began to seek more diversification in their portfolios. Historically, investors stuck to their home markets with their investments. But with the emergence of modern portfolio theory, U.S. investors began to venture abroad with their securities investments. This move abroad brought new risks, in the form of currency fluctuations that needed to be hedged. For example, in a portfolio of foreign bonds, currency fluctuations tend to be the largest source of return volatility. Global bond investors were therefore among the first investors to consider currencies as a risk and recognised the need to actively hedge this risk. Similarly, for many years, currency fluctuations were largely ignored among equity investors due to the relatively higher returns delivered by equities. The tide only turned when the dot-com bubble burst. As equity returns slipped, evaluating currency risk entered the radar screens of international equity investors.
The second step in the development of FX investment, which also originated in the U.S., followed at the end of the 1980s and beginning of the 1990s. Big U.S. pension funds, simply due to their size, began to increase their overseas investments and to consider currency not only as a risk that requires hedging but as an opportunity for active management.
The third phase – which we are currently in – was initiated again through pension funds, but this time in Europe. Many pension funds have been facing large gaps between their pension assets and their long-term payment liabilities for several years. Also, many of these pension funds started to invest in bonds with long maturities. As a result, long-term yields began to sink to the point that long-term bond returns may be insufficient to cover the liabilities. Thus, pension funds developed a stronger interest in alternative investments, and, together with absolute return funds, currencies gained a larger following.
Q: Approaching currencies as an asset class is also a new strategy for PIMCO. How did this view evolve?
Kressin: It is not unusual for PIMCO to enter markets as they evolve. In 1994, for example, PIMCO did not use interest rate swaps because we felt that the transaction costs were more advantageous to Wall Street than for our clients. As swap volumes increased and transaction costs decreased, PIMCO started to use swaps where client guidelines allowed and we continue to use them in many strategies today.
In the past 18 months, our global team has pioneered a new approach to capture currency alpha that potentially offers a more consistent source of returns. Over the longer term we think that our approach offers value to investors in a more traditional global bond mandate as an uncorrelated source of alpha through the inherent diversification in PIMCO’s FX strategy.
Q: FX markets should then be very efficient, given the high liquidity and transparency.
Kressin: Yes, FX markets are highly liquid. Trading is completely transparent, which is reflected in the very tight spreads between the buyers’ bid prices and sellers’ asking prices.
But for a market to be truly information efficient, prices have to be based on profit maximisation by the market participants and there should be no friction in the transmission channel of rational expectations into market prices. This is not always the case with currency markets. Maximising the profit potential of FX trading is not the driving force behind the buying and selling of currencies by importers and exporters, for example. Trading activity in this case is based on trade flows of goods.
Information efficiency assumes that prices form based on similar valuation models. But no commonly agreed on pricing model exists in FX markets. This means that information is processed differently by various market participants. Thus, the same information can have varying impacts, and this lack of a standard price finding mechanism creates inefficiencies that can be exploited.
Another factor in this context is the influence from central banks or political pressure on a currency. Even though currencies in the developed world are floating freely, exchange rates are nevertheless subject to influences often unrelated to economic fundamentals or profit maximisation.
Q: What is the political importance of a currency?
Kressin: To answer this question we have to take a step back and remember what currencies actually are. Currencies are a means of payment and a relative price of equal goods in two economies. The exchange rate thus becomes a factor in global competition. A strong increase in a country’s currency basically translates into a cost disadvantage in global markets, for which an economy first has to make up with efficiency gains. Accordingly, currencies often take a relatively high priority with politicians, and sometimes central banks give in to that pressure, intervening in the currency market in an effort to keep the currency from rising or, in some cases, from falling.
In the long run, interventions can’t stand up against fundamental data, though. We saw what can happen at the beginning of the 1990s when the European Monetary System (EMS) broke up. George Soros and other speculators realised that the set exchange rate for the British pound was unsustainable, given economic fundamentals. Soros and others speculated that the pound would depreciate. The Bank of England intervened repeatedly against the market but eventually the U.K. had to announce its exit from the EMS and the pound weakened markedly against other currencies.
So, FX markets are layered with external influences, as these examples show, and are, as a result, not always efficient despite their high liquidity and transparency.
Q: Don’t these external influences create potential risks for investors that are difficult to quantify?
Kressin: In the short term, this is mostly correct for a non-diversified investment. But an investor, who can identify the structural inefficiencies in the market and use them in a disciplined approach, may be able to increase the potential for a positive return over the long term. To dampen the volatility and risks resulting from these non-controllable events, a currency strategy should seek to diversify these risks as much as possible.
Q: How does PIMCO achieve diversification in its FX approach?
Kressin: Generally, currency investors can diversify in two ways. First, a currency investor can diversify along currency pairs. Second, a currency investor can employ multiple trading strategies rather than rely on a single trading strategy. PIMCO’s approach to FX investing combines both of these sources of diversification.
Q: Which currency pairs does PIMCO use to diversify its FX exposure?
Kressin: PIMCO’s currency approach focuses on the most liquid currencies in the market, which include the U.S., Australian and Canadian dollars, Swedish krona, euro, pound sterling, Swiss franc and yen. This may seem like a small number, but any of these eight currencies can be played against any other, which offers us 28 different currency pairs to choose from in attempting to diversify our exposure.
Q: What strategies are available for PIMCO to diversify FX exposure?
Kressin: We use four approaches to invest in currencies, which we call the Carry, Trend, Volatility and Value approaches. The Carry strategy attempts to capitalise on differences in interest rates between two countries, while the Trend strategy essentially involves finding a major market trend and following it. The Volatility strategy employs options in an attempt to capitalise on other investors’ aversion to the potential risks in currency trading, and the Value approach focuses on identifying value through analysis of a country’s economic fundamentals.
Each of these four strategies is largely independent of the others in terms of the factors that determine success. So PIMCO’s approach is to gain exposure to currencies that appear the most attractive from the perspective of all four strategies, which we believe is a more diversified approach compared to evaluating a currency based on just one trading strategy.
Q: What happens if the four FX approaches give conflicting signals?
Kressin: Different indications from the four approaches are a clear signal to be cautious and to avoid allocating too much risk in that currency. If an increasing number of approaches points in the same direction, it is a sign to increase the risk budget in a specific currency.
Q: Could you give an example of how PIMCO’s approach might offer an advantage compared to focusing on a single FX trading strategy?
Kressin: The potential advantage of PIMCO’s approach can be shown with the example of the carry trade. Over the last several years, the primary carry trade has been to short the Japanese yen because of low short-term rates in Japan. But let’s also keep in mind that exchange rates are relative prices of two economies and therefore a competitive factor.
In the extreme case, where all market participants put on yen carry trades, the yen would fall markedly. The Japanese economy would gain such a huge competitive advantage over other economies that exports would likely go through the roof while imports would drop sharply. A trade surplus of that magnitude would lead to excess demand for yen in FX markets because a Japanese exporter will want to exchange the euros or dollars he receives for goods sold abroad for yen. This leads to an upward pressure on the yen, as opposed to the downward pressure from the carry trade. This means that excess exports will drive the yen higher, back to equilibrium – and carry trades will suffer at some point.
The same example from a Value perspective would look at valuations. A 3% or 4% undervaluation of a currency against its fair value is not significant. But an undervaluation of maybe 30% makes a big difference in trade relationships. It indicates that imports and exports will react accordingly and that an automatic mechanism to regulate their levels should play out.
The point is that any of the four currency strategies on its own is subject to factors that can lead to potentially a sudden reversal. We believe that employing a combination of the four approaches offers a more reliable capital allocation model.
Q: How do you determine the fair value of a currency?
Kressin: The classic valuation approach of a currency is based on the Purchasing Power Parity theory (PPP). Economist Gustav Cassel noted at the beginning of the 20th century that people will purchase an equivalent good in the country where it is relatively cheaper, based on currency differentials. However, the theory has its drawbacks.
PPP compares two static, identical economies and doesn’t consider two important factors. The first is productivity differentials. If productivity growth is higher in one economy than in the other, the economy with higher growth has a competitive advantage because it can produce its goods cheaper. As a consequence the currency of this economy can appreciate without creating competitive disadvantages because a company, in said country, can potentially lower the costs of an item due to its higher productivity.
The second factor refers to so called terms-of-trade shocks. Let’s take, for example, an exporter of commodities like oil or copper that experienced large price increases. This increase is positive for an exporter because the exporter earns a lot more money for the same amount of exported goods and can hence afford more imports. If import prices stay stable, an export surplus in volume terms will result. A currency can then appreciate due to the terms-of-trade shock without changing anything in the trade relationship. This is at the moment especially true with the Australian and New Zealand dollars.
Based on the PPP theory alone, an investor would conclude that the currency in both cases is overvalued and sell the currency, even though there is no overvaluation. So, going beyond PPP in our approach is very important in determining the value component as these examples show.
Q: How would you sum up the various aspects that make currencies an interesting asset class for investors?
Kressin: An important factor is to understand that – contrary to conventional wisdom – the currency market does provide excess return opportunities. There are three reasons for this: varied motivations of market participants, widely differing views on a currency’s fundamental valuation and the size and liquidity of the market, which allow efficient execution and trading.
A systematic FX strategy such as PIMCO’s that seeks to capture value across multiple dimensions can generate consistent excess returns that are largely uncorrelated with other asset classes. This allows an investor to move up the efficient frontier by adding currencies to an existing portfolio of equities and bonds.
Q: Thank you, Thomas.