Worldwide, investors in fixed-income portfolios share a common concern — the risk of rising interest rates as global economies recover and central banks tighten monetary policy.
However, an environment of higher interest rates also tends to offer opportunities for active fundamental management of developed market (i.e. G-10) currencies. Not only is the addition of this traditional investment strategy a natural diversifier for the duration risk in bonds, but it also appears to potentially have become timely, after being out of favor since the global financial crisis beginning in 2008.
Active fundamental currency management prospectively stands to see improvement as currency volatility recovers. Indeed, currency is one of the few asset classes where active managers tend to benefit from volatility.
Volatility appears to be rising in currencies and might be entering a period of elevated levels. As greater dispersion of G-10 gross domestic product occurs, and as developed economies depart from homogenous global central bank monetary easing in response to the 2008 crisis, it is very possible that dispersion in G-10 currency performance also will rise. This relationship between higher GDP and currency dispersion has historically been the norm.
Simply put, as economies recover at different speeds, their currencies rise at different times, and they tend to rise owing to expectations for higher interest rates and future levels of inflation.
Bond duration risk and currency volatility appear to be negatively correlated. When a central bank raises interest rates, or ceases purchasing its country's debt, or its local economy begins to show signs of prospective GDP growth and inflation, duration-risked fixed-income investments tend to enter a period of decline. At the same time, the related currencies tend to rise in the hopes of providing higher short-term interest rates. In essence, currency acts like a very-short-duration note. In such an environment, one currency is likely to perform well relative to others, as higher rates imply a positive short-term interest rate differential vs. other lower-yielding currencies.