The currency market is the largest and most liquid market in the world, with an estimated $7 trillion traded a day and growing. This daily volume is higher than the Tokyo Stock Exchange, NYSE, and London Stock Exchange combined. Despite the opportunity for high returns that are often uncorrelated with other asset classes, investors have been reluctant to give currency allocations the place they deserve in portfolios. Why have so many investors overlooked currency plays, and how are others tilting their portfolios in this era of unprecedented market distortion?
Until now, the astronomical expansion of central bank balance sheets, coupled with fiscal stimulus in response to the pandemic, has been a huge boon for equities and has managed to keep fixed income alive (barely). Indeed monetary policy since the ’70s has lent itself to passive investing in the traditional 60/40 split between stocks and bonds. Why worry about diversification when central banks have had a permanent put on the stock market since the days of Alan Greenspan? However, we are now starting to see the spillover effects of this blowout monetary policy — namely, simmering inflation and widening inequality. The rhetoric in the recent Fed meeting indicates that Chairman Powell may have woken up to the sobering reality that inflation is heating up at an alarming rate.
The Fed is caught between a rock and a hard place. If they increase rates, they run the risk of crashing markets. Global private and public debt has gone from 200% of GDP in 2000 to 360% of GDP and rising as of 2021. In advanced economies, the number is even larger at 420%. In China, it’s 330%. As the Fed is painfully aware, the higher cost of financing all this debt may lead to bankruptcies.
On the other hand, if they keep rates low, they risk losing control over inflation and perhaps even facilitating hyperinflation. In fact, Bank of America strategists recently analyzed the number of mentions of “inflation” during earnings calls, concluding that “at the very least, transitory hyper-inflation [is] ahead.” While it may seem unlikely that central banks would allow us to descend into a Weimar Germany scenario, considering how high fiscal deficits are, it looks like the only way out of all that debt is to inflate away the real value of debt burdens. Some such as Nouriel Roubini would contend that we are now in a situation known as “fiscal dominance” or “debt dominance.” Fiscal dominance means that central banks can no longer remain independent because raising rates in a world with so much debt would crash debt markets and the broader economy. In such a situation, it is important to consider what (if any) ammunition do central banks still have left at their disposal. The fact that they are experimenting with digital currencies could be an indication of what is to come. Not only are many investors concerned about the medium to long-term horizon, but the recent hawkishness from the Fed may also prove Roubini wrong about the Fed allowing inflation to run hot.
Could tighter monetary policy spell trouble for stocks and global debt even sooner than some have anticipated?
Manas D. Kumaar, Group CEO
Would an exogenous shock merely cause another sharp decline and rebound in risk assets — the so-called “V-shaped recovery” that we’ve become so accustomed to in this era of central bank intervention? Or could we see a more sustained slump? For instance, following the Great Depression, the S&P 500 crashed from its peak in 1929. That high was not again seen until 1956, some 27 years later.
The forward-looking P/E ratio of the S&P 500, based on the next 12 months of forecasted earnings, is currently 21.7x. Goldman Sachs expects it to remain similar at 21.3x by year-end 2021. This would rank in the 93rd percentile since 1976.
This multiple means the market is happy and willing to pay 21x the true value of a company’s stock — all this, just to keep the equities market bullish for the sake of an inflated bull run?
Overpaying for earnings today leads to lower rates of return in the future. Michael Burry, the famed “Big Short” investor who bet against the housing crisis in 2008, has bluntly stated that we are in the midst of the “greatest speculative bubble of all time in all things. By two orders of magnitude.” Many optimistic analysts offer rationalizations for the current valuations, but do any of their justifications hold up under any real objective scrutiny?
While some investors may see events such as the Fed buying junk bonds as a reason to be bullish on stocks, other investors might see that as a warning sign, indicating that the system as we know it is has become markedly distorted. Fundamental drivers of value are no longer in lockstep with prices.
In light of current developments, how are investors positioning themselves? Many would consider overpaying for corporate earnings as preferable to sitting on the sidelines, watching cash evaporate due to inflation. On the other hand, many are cognizant that if the Fed gets serious about hiking rates, it could halt the bull run. Another potential risk catalyst for stocks could be a surprise economic growth setback. That scenario may make it more difficult for the Fed to tighten policy in a bid to combat inflation. Fiscal stimulus has accounted for 11.5% of the economy in 2021. That boon for growth may not remain as high in 2022.
In times gone by, a tilt toward fixed income would have sufficed. Today, the world is awash with negative-yielding debt. Prior to the last economic cycle, nominal negative-yielding debt had never before been seen on any meaningful scale in the 4,000-year history of interest rates.
Moreover, inflation is concurrently rising. While many bondholders are paying negative nominal yields, a lot more are enduring negative real yields. For example, if US 10 Year Treasury yields are 1.5% and if inflation is 3%, then bondholders lose 1.5% in real terms. Bondholders will typically demand compensation for higher inflation. However, considering central banks are buying so many bonds, it could be the case that central bank demand is swamping whatever fears bond speculators might have. Could a cyclical shift to an era of persistently higher inflation finally end the four-decade bull market for bonds? Some would say the bond market is simply telling us that inflation will be transitory. Others, such as Billionaire hedge fund manager Paul Tudor Jones, have a different opinion. Jones, one of the most famous macro traders of all time, recently told CNBC, “the idea that inflation is transitory, to me … that one just doesn’t work the way I see the world.”
Is a greater allocation to commodities a prudent move? Jones and many other analysts would agree that it is sensible to increase weighting toward commodities as an inflation hedge. The risk in commodities is if the Fed turns decidedly hawkish and if inflation does indeed turn out to be transitory. Money has been flowing into commodities for quite some time. The inflation upside could potentially already be priced in.
As investors are sizing up their options, this again brings us back to why currency strategies have largely been ignored as a potential core portfolio holding or even as a satellite holding.
The use of leverage by a fund manager is a factor that investors need to consider regarding any hedge fund strategy. In the minds of some investors, currency hedge funds have historically been associated with opaque, highly leveraged strategies. For instance, the near-collapse and subsequent bailout of Long Term Capital Management (LTCM) in 1998 highlighted the dangers of excessive leverage, leaving investors more reluctant to explore absolute return strategies. Moreover, the strong bull run in stocks meant that investors never had any incentive to depart from their traditional Benjamin Graham-style mix of domestic equities and bonds.
However, many sophisticated investors have long done away with traditional asset allocation strategies. A subset has been emulating the endowment model, pioneered by the late great Yale Endowment CIO, David Swenson. Swenson spectacularly increased Yale’s endowment from $1 billion to $32 billion over the course of his monumental tenure from 1985 until his tragic passing last month. Were it not for his courage to break from the herd, and if he merely invested in the S&P 500, the endowment would have grown to only $24 billion, according to Bloomberg. The savior of Yale gave his final lecture on May 3rd before sadly passing away due to cancer two days later. He relied on picking external advisors rather than having a large in-house team engaged in security selection. Swenson created a reliable network of fund managers built on loyalty, rapport, and mutually beneficial incentives. By last year, only 2.5% of Yale’s holdings were in US equities, while bonds and cash accounted for just 7.5%. Instead, the portfolio was dominated by absolute return hedge funds (23.5%), venture capital (also 23.5%), and leveraged buyout or private equity funds (17.5%). However, allocations to deeply illiquid venture capital and private equity investments made life tough for the big endowments during the global financial crisis.
In the currency market, there are no such liquidity concerns.
Another factor that may have dissuaded investors from seeking out a currency strategy has been the performance of many currency funds relative to the broader market. Currency strategies can be broadly classified into three types; carry strategies, trend-following strategies, and value strategies, as per the seminal CFA Institute research paper by Pojarliev and Levich (2012).
Carry trading has not performed strongly over the past decade. The currency carry risk premium has been correlated with the value and size premia in equity markets, meaning that investors in such strategies may not have been getting the diversification benefits that they might have hoped for from carry exposure. All three factors are positively correlated with overall market risk sentiment. The carry factor has become even more correlated with stocks in times of market turmoil — precisely when its diversification benefit is needed most. Novice investors often mistake the carry trade for a riskless arbitrage opportunity. In contrast, seasoned investors are well aware of the tail risk accompanying the negative skewness and excess kurtosis of carry return distributions. Moreover, in the currency market, carry returns have been significantly negative since the Financial Crisis in 2008, as illustrated by the chart below.
Much of the poor performance of the HFRX Risk Premia Currency Carry Index was attributable to its emerging market exposure, which suffered large drawdowns after 2008. Schulze (2021) examined the carry strategy between 2008 and 2017, using the more traditional Australian dollar (AUD) and New Zealand dollar (NZD) as investment currencies. As Schulze excluded EM carry plays from his dataset, he found that the risk-adjusted performance of a developed market carry-trade portfolio is considerably higher than a passive investment in the S&P 500 index. Similar to his portfolio, the EM-free Citi G10 Carry Index shown below suffered fewer drawdowns during the financial crisis.
These returns were still underwhelming relative to stocks. Additionally, now, rates in Australia are 0.1%, and rates in most other developed countries are similarly low or negative. Many traders would argue that the only attractive currencies for carry harvesting are emerging currencies such as the Brazilian real (BRL) or Russian Ruble (RUB). The issue with these EM currencies is that they are notoriously volatile. The carry trade relies on low volatility because it is effectively a form of short volatility trading. The kurtosis risk and skewness risk inherent in carry trading could be called a “Taleb distribution,” named after the author of “The Black Swan,” Nassim Taleb. Taleb likened such strategies to “picking up pennies in front of a steamroller.” Moreover, the spread between high-yield and low-yield currencies has become quite compressed due to harmonization in monetary policy across the developed world. It now requires more risk to reach for yield. Thus, many would argue that collecting carry in the currency market is not as attractive as it once was.
The value strategy in currency markets is based on purchasing power parity (PPP). PPP is an economic theory conceptualized on the premise that identical goods in different countries should have the same price in the absence of transaction costs. Value investing in currencies has long been employed by some global macro strategists, given its underpinnings in macroeconomic theory. However, it requires great conviction in that macroeconomic theory, given how markets can diverge from theoretical assumptions for quite some time. Additionally, the time horizons over which rates are expected to reach equilibrium can also be open to interpretation.
As shown in the below graph, currency value strategies have fared better than carry strategies on aggregate since 2008. Notably, there has been a slight inverse correlation between the Barclays G10 FX Value Index and equity markets. Since December 2006, it has exhibited a beta of -0.02, while G10 Carry has had a beta of 0.2 over the same period. However, despite the diversification benefits that have accrued to value strategies, their returns have also been underwhelming.
Similarly to carry strategies, there has been a pronounced difference between value returns in developed markets in contrast to emerging markets. This contrast is highlighted in the below comparison of the HFR Currency Value Index and the Barclays G10 FX Value Index. The HFR Index includes EM currencies, which are more volatile than their historically range-bound G10 counterparts.
Trend following and momentum-based strategies differ significantly from the aforementioned strategies in that they exploit patterns rather than fundamentals. Whereas carry and value strategies are theoretically based on fundamental determinants of currency value, trend-following and momentum strategies are predicated on the assumption that the weak form of the Efficient Market Hypothesis does not hold. In other words, future price movements can indeed be predicted by historical price data. Empirical evidence on the profitability of trend following rules has validated this assumption (Pojarliev and Levich, 2012).
While once scorned by academics, the closely associated time-series and cross-sectional momentum strategies have also become widely accepted in academic literature since the seminal publications by Jegadeesh & Titman (1993) and Carhart (1997). The CTA and trend-following hedge fund industry were well aware of this market inefficiency long before the academics. Simply put, securities that have performed well tend to perform well in the future and vice versa. Historically, transaction costs have eroded the excess returns that would otherwise have accrued to high volume trend-following and momentum strategies (Menkhoff et al., 2011, Hurst, 2014).
As illustrated by the graph below, there has been a slight negative correlation between trend-following strategies and the stock market, which is why such funds frequently market their strategies for tail risk hedging purposes. Many sophisticated investors are willing to forgo returns for downside protection and a better Sharpe ratio. An uncorrelated or negatively correlated holding can, of course, bolster risk-adjusted returns for the portfolio as a whole.
While style factors are important for dissecting returns, market beta alone tells us a lot about a strategy’s systemic risk profile. The Barclays G10 Currency Trend ER Index has had a market beta of -0.026 since December 2006, while the better performing EM Currency Index from Barclays has had a slightly lower beta at -0.024. Trend following equity strategies will naturally have a higher beta in a bull market, during which the trend is with the market. However, during bear markets, their diversification benefits shine. EM currency trend-following strategies have generated significantly higher risk-adjusted returns than their G10 counterparts over the past decade and the past 20 years.
Despite the above solid performance post-2008, some authors such as Hutchinson and O’Brien (2014) found that trend-following has tended to underperform following financial crises, since as far back as the Great Depression. Perhaps more importantly, going forward, the less-than-stellar performance of trend-following strategies over the past decade, and indeed since 2003, begs the question — what has changed in markets?
Many would assert that the decline has been due to the rise of algorithmic trading. As it became easier for technical analysts to implement rules-based trading algorithmically, and many new participants could exploit the strategy with more discipline in the information age, the returns declined. These advances may explain why trend-following has outperformed in emerging markets, which might not have as many sophisticated market participants.
In addition, market anomalies often disappear as they become known. For example, McLean and Pontiff (2016) found that strategy returns were 58% lower post-publication. The widespread knowledge of previously secret tactics may explain the relative underperformance of trend-following since 2003. The predictable trading rules of these once effective strategies can easily be exploited by more sophisticated traders, who can, for example, anticipate where their competitors will set stop-losses and limit orders.
Therefore, it may be that the strategy has become more and more obsolete. Simply put, it is becoming harder and harder for archaic strategies to exploit anomalies based on basic technical analysis due to the exponential advancement of technology and data at the disposal of quants and high-frequency traders. When we consider this fact in light of the challenges facing other asset classes, as previously discussed, it’s clear why investors may be reevaluating their willingness to differentiate between traditional technical currency strategies and more sophisticated modern ones.
WHY THE CURRENCY MARKET?
Investors need a currency strategy that is both uncorrelated with the global economy in times of turmoil and attractive in terms of absolute returns. Simply put, investors need a smarter currency strategy.
Using time, speed to market and bespoke liquidity solutions from the right sources can offer investors a significant advantage in being able to exploit the inefficiencies that exist in the market. Furthermore, the decentralised nature of the currency markets makes it possible to access the right liquidity and use technological advantages (such as speed, execution excellence and broker surveillance) to tap into micro profits that are substantial cumulatively.
The ability to enter and exit a trade with precision and by eliminating the human element, algorithmic trading can provide the type of returns that aren’t affected (much) by volatility or the typical fundamental drivers that affect other asset classes.
PWE Capital is a High Frequency Trading firm focused on the currency, commodities and equity indices markets. With a unique direct-to-bank trading environment and access to high volume, big ticket liquidity, PWE Capital is positioning itself as an emerging pioneer in applying mathematical, technical trading models that embrace the volatility and chaos in the currency market to generate profits without any trend bias, carry-overs or reliance on any one particular strategy.