After years in the doldrums, currency movements are once again dominating the headlines. Both the yen and sterling have weakened significantly against the US dollar over the past year, losing 12% and 6% respectively.
“If currency risk is not properly managed it is like an iceberg in the portfolio. People have underestimated the impact because there is a view equities are a natural hedge. That’s wrong.”Johanna Kyrklund
The re-emergence of volatility in the currency markets has re-awoken investor interest in this asset class, with spread betting firms reporting a doubling in currency trading volumes in recent months.
While speculating on short-term movements does not fit with the investment philosophy of most institutional investors, the move away from stagnation in the FX markets means that now is a good time to take a closer look at both the positive and negative aspects of a more revitalised currency market for long-term investors.
Before the financial crisis, there was plenty of discussion about adding currency as an asset to an alternative basket. But the long-term ramifications of the financial crisis dampened currency volatility and made it much less appealing as an asset class.
James Wood-Collins, chief executive of Record Currency Management, says: “There were a number of unusual circumstances from 2008 to 2011 that muted the normal behaviour of currency markets.”
Those included very low interest rates and hence very narrow interest rate differences between developed market currencies. “That in part resulted in very weak trending behaviour which is usually a strong driver of currency markets,” adds Wood-Collins.
While currency volatility has started to return to the market, the currency markets have changed the way they behave. “Historically there was relatively little intervention by central banks directly in the currency markets, with most relying on conventional macroeconomic policy using interest rates as a key tool,” adds Wood-Collins.
Releasing the pressure
But over the last few years, there has been much greater central bank intervention in currency markets directly as well as in fixed income markets, which has stoked investor fears over “currency wars”. Certain currencies have also acquired more pronounced “risk-on” characteristics, while others have become established as “safe havens”.
Perhaps the most interesting question is why currency market volatility has returned in recent months given that central banks are still heavily focused on intervention and interest rate differentials between the developed countries remain low.
Wood-Collins says: “Central bank intervention can only work for a period of time. But pressure builds up in the currency market and eventually that will be significant enough to cause markets to fracture.”
Take the yen’s sharp devaluation against the dollar. Until October 2012, it was trading in a narrow range but the result of the cumulative build-up of policy statements by the new Japanese administration and expected policy moves by the Bank of Japan resulted in a very sharp and pronounced move.
Calm before the storm
The return of volatility in currency markets is not only caused by the release of pent-up pressure from central banks, but also by a shift in the outlook for the global economy.
There is a growing sense from investors that the world has become a slightly less risky place. Adrian Owens, fund manager of the GAM Star discretionary FX fund, says: “Mario Draghi said that the ECB would do whatever it took; this has helped to remove some of the risk premium in markets making them much calmer. Calmer markets allow investors to focus more on fundamentals.”