Currency volatility can be antidote for interest rate risk

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.

Among some of the solutions that seek to offset bond duration risk — bank loans (with floating interest rates and no duration), equity income strategies (with variable income from dividends) and fundamental currency management (which can benefit from rising short-term interest rates) — the latter solution has perhaps the least basis risk. The embedded credit risk in non-investment-grade bank loans and the equity risk in equity income strategies provide basis risk vs. an asset allocation to investment-grade bonds because they introduce credit and equity risks that are not well-suited or exactly matching the corresponding investment-grade nature of the portfolio risk that investors are trying to offset. Alternatively, fundamental currency management has fewer of these basis risks and is, therefore, perhaps a more accurate offset to rising interest rate risk.

Since the 2008 crisis, fundamental currency investing has been an out-of-favor strategy. Return generation has been challenging, as many developed-market central banks have been engaging in homogenous monetary easing. Since 2010, G4 balance sheet expansion has depressed foreign exchange volatility. Volatility is a positive for the currency asset class, whereas for many other asset classes volatility is not associated with a positive environment. Volatility in fundamental currency management can enhance the opportunity for performance from active managers.

Central bank action also has caused short-term interest rates among these countries to collapse. With interest rates across several major currencies close to zero, generating returns on interest rate differentials becomes more difficult. As a result, the median active currency manager return was low or, in some periods, negative over this time frame.

G-10 currency returns dispersion might have troughed, in which case the outlook for fundamental currency investing as an asset class may have improved.

As G-10 economies emerge from weak economic conditions (and at an uneven pace), it is possible that there will be greater dispersion of GDP growth rates among these regions and that their central banks may begin to operate in a more heterogeneous fashion. Increased dispersion among G-10 nation GDP growth rates typically is correlated to increased dispersion among their currencies.

The U.S. may be ahead of the European Union in emerging from economic stagnation. The prospect for some improvement in unemployment and increase in inflation in the U.S. has resulted in Federal Reserve members being somewhat divided on when the central bank should cease its purchases of U.S. Treasury debt. Such a cessation might be viewed as tantamount to raising short-term interest rates in terms of the bond market's reaction and potentially causing strength in the U.S. dollar. An additional implication could be weakness in the dollar-denominated price of gold, which in recent history has had a negative correlation of -0.28 (1980-2012) to the trade-weighted performance of the U.S. dollar.

The currency asset class might be entering a virtuous period with enhanced volatility and opportunity for active managers, provided by less central bank balance sheet expansion and increased G-10 GDP growth dispersion. Fundamental currency management could be a compelling strategy to pursue to ease some duration risk in bond portfolios, providing less basis risk than some other mitigating strategies, such as floating-rate non-investment-grade bank debt.

Although this article focuses on G-10 currency relationships, emerging market currencies offer additional opportunities. A number of emerging market countries offer positive real interest rates, compared with negative real interest rates for many developed market countries.