Dollar At Risk? Case for Managing Currency Risk

By: Axel G. Merk, Merk Investments / GoldSeek.com

The “cleanest” dirty shirt, the U.S. dollar, is down versus the euro so far this year; and was down last year. Yet, S&P, in upgrading the credit outlook of the U.S., cites U.S. dollar strength. If this is a strong dollar environment, are investors prepared for a weak one? With plenty of dirty laundry in the world, we ponder how investors might be able to profit from actively managing currency risk.

Not managing currency risk may be risky. When holding U.S. dollar cash, if nothing else, one risks the erosion of one’s purchasing power. When adding non-dollar currencies to a portfolio, one clearly adds rather than removes risk when judged in terms of U.S. dollar returns, but it might be a risk worth pursuing. Let us explain:

The “mania of policy makers” might be best expressed in currencies

Investors buying equities in hopes that all the “money printing” (quantitative easing, “QE”) may lift asset prices are taking on a great deal of ‘noise’. We believe asset prices may no longer reflect fundamentals, but instead reflect the next perceived move of policy makers. We believe the currency markets may be a great way to express one’s view of what we call the “mania of policy makers,” as currency movements may provide a far more direct reflection of what policy makers are up to.

Differently put: you may not like what President Obama, German chancellor Merkel, or Japan’s prime minister Abe are up to, but we believe they are rather predictable. The same applies to central banks around the world.

Currencies For Dummies

“Currencies are too complicated!” is about as enshrined in investor’s thinking as the myth that fiat¹ currencies are worth more than the paper they are printed on. When we look at the equity space, we see thousands of stocks. Why exactly is the share price of Apple down from its peak despite Apple being a great company? Sure, the pundits have figured it out now, but how many identified the peak? Well, stocks don’t have to be complicated: Abby Joseph Cohen at Goldman Sachs is famous for all too often proclaiming stock prices have the potential to move up 10%, just about no matter where stock prices are.

In the currency space, there are 10 major currencies, then a limited number of smaller ones worth following. We think it’s a space that’s much more easily followed. As long-term readers of Merk Insights know, we spend a great deal of time explaining dynamics in the currency space. You don’t have to know the latest and greatest carry trade strategy to make money in currencies, just as one doesn’t need to know all about Fibonacci retracements to make money in equities. However, just like any investments, one does need a coherent framework to look at the market. Our framework happens to be monetary policy, a very fertile base given the active involvement of policy makers. At the risk of over-simplifying, consider this chart depicting growth in central bank balance sheets of select major economies, as a proxy for the amount of money that’s been “printed” (in quotes as no real physical currency is printed, but currency is created by the stroke of a keyboard):

Is it all that surprising that the euro is strong despite trouble in the Eurozone when liquidity is being mopped up? Is it all that surprising that the yen is weakening as the printing presses are ramped up in Japan?

Bonds or Equities? Currencies.

In our discussion with investors, a dominant concern is what may happen to the bond market. Some are concerned about inflation; many are concerned about economic growth: either way, bond prices might be at risk. Yet moving from fixed income to equities likely increases the risk profile of a portfolio. What about investors that are not gung-ho about equities given what might be overvalued levels in the U.S. stock market?

The alternative might be currencies. Like international fixed income, currencies provide non-dollar currency exposure. But unlike bonds, the typical currency investment minimizes interest rate and credit risk. While it’s been profitable in recent years to take on those risks, chasing yields might increasingly become a risky proposition. Some consider currency investing a special case of international fixed income investing, just on the very short end of the yield curve.

Currencies offer low correlation to traditional asset classes

Most investors have heard currencies may have a low correlation to other asset classes. But what does that mean? There are two basic ways to look at currency investing: directional versus non-directional:

When looking at directional currency investing, think of the U.S. dollar versus a currency, a basket of currencies (such as the dollar index) or a managed basket of currencies (such as a mutual fund). Over longer periods, directional currency investing has historically generated returns that have a rather low correlation to other asset classes, including a negative correlation to bonds. However, directional currency investing is not completely immune to the risk-on / risk-off sort of environments we experienced with some intensity until especially last summer. The good news is that these correlations have been breaking down.

However, currencies also allow investors to design a portfolio that has a low correlation to other asset classes independent of the market environment. We are talking about non-directional currency investing, such as taking a position on the New Zealand dollar versus the Australian dollar. Before you roll your eyes and say “I told you it’s complicated,” consider the following:

• The Australian dollar’s fate is closely linked to the fate of hard commodities; of late, the Aussie has had some challenges.
• The New Zealand dollar’s fate is more closely linked to soft commodities. Most recently, global dairy prices have been on the rise.

Assume now you want to take a position that the Kiwi, as the New Zealand dollar is called, will rise versus the Aussie. While no one can guarantee that you can make money with that sort of trade, it is reasonably certain that the returns generated with this pair will have a very low, if any, correlation to just about anything else in most investors’ portfolios. The power of non-directional currency investing, most commonly found in absolute return types of strategies, is that it may be able to add uncorrelated returns to a portfolio.

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