In this article we discuss why investing in Currency Strategies are a strong consideration for the markets ahead. Quantitative Easing (QE) on an unprecedented level, and the adoption of Zero Lower Bound (ZLB) monetary policy by central banks across the globe were the lead solutions to the financial crisis. These solutions have had an enormous impact on almost every asset class and economy over the last 8 to 10 years and continues to have a defining impact on markets today. It is also likely to both positively and negatively magnify and distort asset class returns long into the next decade. Most importantly the sheer scale of the solution and the long-term impact this could have on future markets should attract the attention of investors.
It is hard to measure exactly the impact of QE and tapering and ZLB monetary policy but some commonly quoted figures on Wikipedia give an indication of the scale of the stimulus that has affected the market.
- U.S. post financial crisis Q.E. peaked at $4.5 trillion in 2014.
- The ECB’s post financial crisis Q.E reached €2.6 trillion in Dec 2018.
- U.K. Q.E with an additional stimulus post the BREXIT election reached £445 billion in 2016.
- The Japanese BOJ’s balance sheet as of Feb 2019 was ¥557 trillion ($5.1 trillion).
This monetary policy wall of money above arrived into the system by Global Central Banks buying predetermined amounts of government bonds, financial assets, “troubled” assets and even equities This in turn has driven returns in traditional asset classes significantly higher over the last 10 years as you can see from the table below.
Index Return (Period 01/06/2009 -31/05/2019)
NASDAQ 100 513%
S&P500 TR 357%
DJ Industrial Average 261%
MSCI World TR Index 229%
NIKKEI 225 140%
JP Morgan Global Bond Index 60%
Some of the additional side effects of QE are (i) lower market volatility which can be attributed to the market knowing the predetermined amount of the buying program and (ii) making the market (somewhat) immune or insulated form market crises, as traditional asset classes now have a natural buyer putting a floor on their securities.
In parallel to QE, the ZLB monetary policy translated to reduced borrowing costs which ideally incentivised investments in wealth producing activities and increased investments in the securities markets. Please see a table of interest rate over the last 12 years (Table 2).
|1st Jun 2007||1st Jun 2014||1st Jun 2019|
|US Fed Funds $||5.25%||0.25%||2.50%|
|ECB Refi Rate €||3.75%||0.25%||0.00%|
|BoE Base Rate £||5.50%||0.50%||0.50%|
|BoJ O/N Call Target Rate ¥||0.50%||0.10%||0.10%|
Source Refinitiv Thompson Reuters
Traditional asset classes bonds, equity and property have performed exceptionally well from QE helping to rebuild investor’s portfolios, but alternative asset classes including Currency Programs have fared less well (for now) due to the unintended consequences of the ZLB Monetary Policy.
Currency Programs seeks to generate returns during the following:
- When the value of one currency strengthens/weakens against another currency (I.e trends)
- When movements in the value of currency pairs (Eur/USD) tend to self-correct and revert to their average
- Currencies with higher interest rates tend to attract capital against those with lower interest rates.
This ZLB policy has impacted Currency Program opportunity sets in recent years creating conditions which were not ideal for the reasons given above.
An environment where there is little interest rate differential can make markets difficult for both yield models and trend following Currency Managers. Similarly, a period of low global market volatility can make it difficult for trends to appear in the Currency market. Also, an environment where global markets are insulated from crises can make it difficult for trends to appear in Currency markets.
However, such monetary policy cannot continue for ever and the present side effects could have lasting consequences on markets. At some point in the future low volatility will be replace by high volatility and markets cannot withstand every shock without some event causing a crisis bear event.
Gradually we are seeing some movement again in interest rates as the differential between the FED rate and ECB rate has moved out to 2.5% (Table 2)
Where can Currency Programs deliver return for its investors?
Environments where trend following Currency programs have made money tended to coincide with periods of high volatility and crisis events for equities. Most notably The Tech Bubble collapse, the Financial Crisis and the European Debt Crisis. Many currency managers attribute the positives returns made in crises to a scenario called Crisis Alpha which explains reasons why some alternative fund managers are good at capturing return in a crisis.
In a Crisis Alpha scenario, the following tends to happen:
- Equity markets go down and realised volatility generally rises.
- Equity investors industry wide, have a long bias and suffer losses and breach risk limits.
- This forces investors into action.
- Large groups of investors flee some asset classes and herd into others desperately seeking liquidity.
- This causes persistent trends across a wide range of asset classes.
- Liquid alternative fund managers who can adapt, can exploit these trends and deliver Crisis Alpha.
Source: In Search of Crisis Alpha Kathryn M. Kaminski Ph.D.
The hallmarks of a Currency program that benefits from Crisis Alpha.
(i) Daily Liquidity
(ii) Both Fast and Slow Currency Trend following models
(iii) Uncorrelated to traditional asset classes
(iv) Long term track record which delivered positive returns in previous crises.
Having had a hugely successful run in traditional asset classes, it may be time to take stock. After years of Central Bank controlled volatility, could we see a period of uncontrolled volatility in markets?
The market we know “climbs a wall of worry” so there will always be something to worry investors if they look for it. That said, in a crisis there is always a trend, the question is are investors aware of where and how to capture it. Trend Currency Programs tend to be uncorrelated to both equities and bonds, offers diversification to a portfolio, and have the potential to capture Crisis Alpha in volatile and crisis markets. Perhaps the scale of the solution to the previous crisis might suggest that the Crisis Alpha could be proportionally larger than in previous crises. Dare we say this time round we could have Crisis Alpha Squared!
Author: Brian Flanagan CAIA Senior Business Development Manager Alder Capital. To find out more about Alder Capital contact firstname.lastname@example.org
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