von Ross Taylor, Director at Absolute Return Strategies.
From time to time, we share our thoughts regarding the state of world affairs; not just from a financial or technical view, but with thoughts on trends underway that will have long-term consequences for every investor.
We will admit up front that our thoughts, and the ideas presented here are expressed with a view to encouraging you to consider the currency markets as a very appropriate and vital place to allocate a portion of your assets and risk, even as we are making highs in many equity indices, and other sectors of the U.S. economy appear to be enjoying a considerable renaissance from the dark ages of 2008/2009.
There are two themes to discuss. The first is the pernicious and dangerous effects that low interest rate policies – almost globally – have had on investor and borrower alike.
The second, in so many ways linked to the first, are thoughts on just how the central banks and governments of the USA, UK, Eurozone, and Japan (this is not the de nitive list) have behaved for the past 10-12 years, what they are doing now, and what they – meaning we the people - are facing.
The Third is our rationale for asset and risk allocation to the currency markets, through professional managers.
I apologize in advance for the history lesson, which is by no means a complete account of all that happened in the post WWII world, but it may help to explain why things got to be where they are today, and some alternative ideas on investing going forward.
Low Interest Rates – ZIRP the Usurper
In modern post-war financial history, there have been two reasons for a country’s level of interest rates to fall to almost zero, or beyond. In the early 1970’s, Western Europe was awash in US dollars accumulated as a result of the tremendous economic boom that began in the wake of WWII and continued without a blink, until the late 1960’s. The dollar was fixed to the price of gold, and most currencies maintained a stable relationship following the 1948 Bretton Woods agreement. Then things changed; the US began to run up de cits, price inflation re-appeared, and all those holders of U.S. dollars began to get nervous that their holdings were in danger of losing value; a fear that proved true when in August 1971, Nixon suspended the convertibility of the dollar into gold.
Safe haven countries such as Switzerland and West Germany began to feel the heat of appreciating currency rates versus the dollar and they did what they could to discourage inflows of short-term capital by curtailing the yield on bank deposits. They even went as far as to impose negative interest rates on foreign depositors who insisted on parking their francs and marks in local banks. There are many other factors that were involved here, but suffice it to say, with the dollar no longer convertible into gold – hence the destruction of a global fixed exchange rate policy – everything changed in international finance, and in particular, a country’s rate of exchange against the dollar – and by extension against its neighbor’s – became fair game for speculators and government economic policy makers alike.
Eventually, those strong currency nations learned to live with the situation, while the weaker ones used their ability to devalue as a means of economic redress. This de nitely included the USA, when the late John Conally, Treasury Secretary in the Nixon administration, informed a group of European finance ministers concerned with importing U.S. in ation that “the dollar is our currency; and your problem”.
I’m getting a little off track but we shall return to review this form of policy shortly. Three events shaped the present state of affairs in world finances, where we are witnessing widely fluctuating growth and unemployment rates, and living from crisis to crisis – be it the banking sector or the national treasury.
The first has its roots back in the 1957 (The European Coal and Steel Community, ECSC formed in 1951 was the rst post-war attempt to unify Europe), with the creation of the European Economic Community – a French-led initiative to create a united Europe, thus creating regional political and economic stability after so much war and destruction. I think it’s fair to say that the founders also had their eyes on countering American dominance.
What started as a tariff-free trade area began experimenting with an intra-bloc currency policy, with a long-term goal of creating one currency for the members, to be followed by full fiscal and political union – a very ambitious plan, given the divergent local economies and cultures involved.
Let’s fast forward to 1992 when the Treaty of Maastricht proclaimed three things: One – there would be a single currency that would replace all the Eurozone national ones; two – there would be strict limits on in ation to be policed by creating a successor to the in ation-paranoid Bundesbank, and three – there would be fiscal discipline with regard to the ratio of government debts and deficits to each member’s GDP.
It was extremely ambitious, politically driven, and economic madness, yet as the date for currency conversion approached – January 1999, somehow all the first 12 members magically got their finances in line to qualify. In return, they got the Euro stamp of approval.
In what proved to be uncannily similar to the mortgage derivative horror years into the future, more member countries were able to borrow money at cheap rates, even going as far as using the derivatives market to hide their true fiscal position. Prior to the Euro, their interest rates and exchange rates had fluctuated wildly before converging as entry into the Euro approached.
The rating agencies waved the AAA wand and the international debt markets opened their arms and wallets to the likes of Greece, Portugal, Italy, Ireland and Spain – as if they were Germany, or France.
It was all good for several years; money was borrowed; money was spent; yet the budget targets were always met. World economic conditions were generally very positive, so meeting debt and in ation targets appeared to be relatively painless, even for the most profligate members.
Now to the U.S. and the second condition for low interest rates. Long term rates had been on a downtrend ever since Paul Volcker stepped into Arthur Burn’s shoes at the Fed and squeezed the daylights out of in ation. There were bumps in the road but up until the collapse of tech-led stocks in 2000-2001, massive corporate fraud, and the World Trade Center horror, the US had survived without too much damage.
In fact, the US remained mostly in a growth phase right up until 2008, but along the way, the then present Fed chairman Alan Greenspan had aggressively used low interest rates as a stimulative tool. In fairness, I will point out that the Japanese have pursued the same low interest rate policy in a fruitless attempt the stimulate their economy, which had been in a slump since the early 1990’s, thanks to globalization, and a collapse of most Japanese banks many years before the 2008 crisis.
Repeating what had happened in Japan many years prior, the US housing and mortgage market exploded to the upside. Mortgage rates were cheap; property prices were on an unheard of upward spiral; lending standards were loosened to the point of fraud in many cases; banks learned new techniques for offloading these mortgages that would have stayed on their books until the sale of the property.
In a relatively low interest rate environment, investors were hungry for yield, and banks were very creative in packaging, slicing, and synthesizing these loans – all with the blessing of the rating agencies, and apparently the regulators. What was safer than a home mortgage? The buyer had ‘qualified’; the mortgage was secured by the property, and property prices never fell. AAA all the way!
Banks and borrowers alike were leveraged to the hilt. No one dared say it, but a small downward blip in house prices would spell disaster. You borrow a dollar to buy something for 100 dollars; the value of that something falls to 95 bucks – you just lost 5 times your investment, all for a lousy 5 percent drop in the underlying.
Why they all got away with it, we may never know. But when it all came unraveled in 2008 and 2009, so much value was destroyed to be beyond repair. The only solution was a government bailout through the creation of trillions of dollars to save failing banks and other significant institutions, and a forced reduction in the cost of money to almost zero thanks to massive Fed purchases of US government debt.
And here we remain. No one knows what the long-term effects of all that money creation will be. It’s supposed to be massive inflation – hence the peak 300 percent run up in gold from $650 since 2007. We do know that asset bubbles are a fact of human behavior – we may very well be witnessing one right now, as stocks soar.
No one knows how the US can repay its debts; no one even knows how they will be able to service them when interest rates inevitably rise. But it doesn’t end here.
While US banks were undoubtedly the leaders in mortgage product, most European banks competed aggressively for a slice of the business. Housing prices went through the roof – pun intended – in countries like Spain and Ireland, only to crash massively. Unsurprisingly, banks had to be bailed out by their respective countries. Global GDP took a massive hit in 2009. Budget deficits were ballooning; tax receipts were down, now public debt levels ballooned.
This was the beginning of the European sovereign crisis. Those poorer, poorly managed, and heavily indebted countries within the Eurozone had to confess that they’d fudged the numbers from the very beginning. Lending between banks had almost stopped in 2008 and 2009. Now no one was going to lend money to a Greece, or a Portugal (and soon to be others) – at least not at German-style interest rates. Ironically, it was cheap money that got these countries into trouble. And now instead of dealing with too-big-to-fail companies, we faced sovereign nations in the same mess. In another twist, Eurozone banks were permitted to carry sovereign debt of any Eurozone country at par, since it was all deemed to be AAA’ish. But as these banks were forced to rapidly shrink their balance sheets, they needed solid sovereign assets, not downgraded and discounted secondary balance sheet capital. The first real crisis was in 2010 involving Greece, who got a bailout, and assurances were made that all was well. This process has been repeated in 2011, and 2012.
Once again, thanks to the authorities’ largesse, the crisis has been muted of late, although the recent Italian election impasse raises many fears. But the European Central Bank has in effect offered to buy the bonds of any Eurozone country that requests assistance with restructuring, and interest rates in these troubled Euro members are now artificially low.
The curse of low interest rates, quite apart from the damage it has done to savers, and other pension plans that rely on fixed income coupons, is thus: Careless and reckless spending, borrowing, and overreaching for dangerous assets to produce current yield. Massive financial inflation – not the kind that necessarily shows up in the Consumer Price Index, but the kind that can destroy individuals and countries alike; asset bubbles that have led to public bailouts whose eventual costs no one dares to calculate. The destruction of traditionally solid institutions that chose to ignore risk.
Currency wars – the new (but very old) economic weapon of choice.
So we get back to currencies. Most of the Eurozone is in trouble – no growth, high unemployment, massive public debt. In the past, some of the members would have devalued to stimulate growth. Now they cannot. For a European, today’s equivalents of the exchange rate are interest rates and high unemployment.
Other countries such as Japan have begun to pursue aggressive moves to depreciate their currencies in order to stimulate their economies. Yet other countries are understandably concerned by this. China, in many ways the sleeping tiger in nancial markets, has sharply criticized the use of the currency weapon – and they were looking at Japan when they said this. The Swiss were forced to put a limit on how far the euro could drop against the franc; the US always advocates a strong dollar, but everyone knows it’s still Conally time when it suits. For the Eurozone as a whole, a weaker Euro would do no harm, especially for the poorer countries whose GDP has fallen by 10-20 percent over the past few years. But weaker against who or what?
It is pretty clear that the British, who wisely decided to remain outside of the Euro currency – being that they have always been serial devaluers in troubled times, appear to be content to guide Sterling lower through hints of massive monetary creation, and are happy to tolerate higher in ation to stimulate growth. The Brits actually invented a name for when this fails – stagflation.
Global trade counts. If a country cannot export its products and services to other countries, then it cannot afford to import the vital goods that it needs to survive – food – energy – minerals – to name a few critical areas. And it will not be able to grow its economy. Globalization is starting to reverse its original trend, as global production costs converge – largely due to the destruction of Western economic prosperity insofar as wage levels are concerned, and the rapidly rising standards of living in the areas that had been the major bene ciaries of outsourcing. Many large US companies earn as much as 80 percent of their revenues from overseas sales; Japan is running a trade deficit for the first time in 40 years, largely due to the effects of the 2011 Tsunami that curtailed industrial activity and sharply increased imports of oil, as nuclear power plants were shut down.
Recent developments in U.S. energy production threaten a massive upheaval of the balance of trade between wealthy Middle East countries – who are heavy consumers of U.S, European and Asian goods and services. This same development threatens to reverse the outsourcing boom that has been so instrumental in the growth of places like China, and India. The US will have a tremendous production advantage over many other developed countries, because it has the manufacturing infrastructure and cheap energy, while the cost of transporting goods back to their home market may end up outweighing any labor cost advantage in those outsourcing nations.
Every country denies that they are engaged in currency manipulation. They all claim that monetary policy is aimed solely at stimulating the domestic economy, but just as they say all politics is local, all local economies are now global.
These are big macro themes that should be taken seriously, and given due consideration by long-term investors, while they consider the best way to profit from what appears at face value to be a series of destructive forces.
Why and How to allocate to currencies as a pure asset class
It will be clear from the all of the above that many countries are in unstable and untenable positions. It should also be clear that currency rates are one of the many weapons of global trade. What is less clear to many investors is that currency relationships fluctuate for a myriad of other reasons. These may be Central Bank reserve adjustments, an international M&A transaction, demand for equity or fixed income assets from an overseas manager, or an unexpected event – political – natural – economic - somewhere in the world.
We buy stocks to benefit from corporate profits; we buy bonds to earn interest; we buy commodity futures if we need to hedge or want to take a view on the future for that commodity – it could be gold, it could be crude, soybeans, wheat, or copper.
Currency trading is largely unknown to many investors, largely because there is no industry performance benchmark. For some, it’s a concept that cannot be processed – the very idea of buying something and shorting something else simultaneously! For them, currency trading is the province of banks and hedge funds, and for some, it’s just a cost of doing international business.
Let’s consider the premise that currency rates do two things: They tend to move in a trending fashion over long periods of time; they also fluctuate quite significantly on a daily basis.
Now this doesn’t make them different from any stock or commodity future in terms of volatility and directional outcome. What makes currency trading unique is that long/short idea that I just mentioned. You want to sell the Japanese Yen because you heard that the Japanese are attempting to lower its value? Lower its value against what? The dollar? The Euro? The Australian dollar, the Chinese Yuan, the Korean Won, Gold? Steel?
The answer right now is probably any other currency that is a major trading partner with Japan. The fact that they’ll have to pay more for steel is unfortunate, but since steel helps create value-added products that can be exported, there should be a net advantage.
But....You choose to sell the Yen against the dollar. All is going well until one day something causes the Dow to fall 500 points, for reasons that have absolutely nothing to do with Japanese economic policy. Suddenly, international investors are dumping US stocks, and US dollars are being converted back to local currencies, and one of those just happens to be the Japanese Yen. This pattern happens dozens of times a day in the currency markets. Small events, news, M&A deals, speculative flows cause a change in the ratio of the Yen to the dollar and to the Euro and the Australian and the Canadian dollar etc. etc. and sometimes for no obvious or apparent reason. Yes, tomorrow you’ll read in the WSJ that currencies rose against the dollar or some perfectly logical reason. Unfortunately, the WSJ only comes out after the market closes, and not before.
Most markets appear to act in a random way over short periods of time. A professional trader can make sense out of those moves, no matter what the instrument. The duality of currency trading may sound even more random and confusing, but think how much information – be it technical or fundamental is available to a professional currency trader.
Here’s another fact that makes currency trading unique: The foreign exchange market dwarfs every other financial market. Over $ 4 trillion are traded daily. It is a very transparent market. It is extremely hard for a single investor to influence the market; there are hedgers and speculators at work simultaneously; there are traders who add liquidity by trading every millisecond; the biggest institutions in the world are involved on a daily basis. During the 2008/2009 crash, the currency markets operated normally without major disruption (other than to shut out a few soon to be defunct players).
The reason that this market is so vast is that every international transaction needs access to the currency market. It is the highway down which all global trade and finance must travel, and it is supported by vast investor interest that seeks to profit from its fluctuations. Every news headline, every economic data point, every geo-political event leaves a footprint.
Entry into the market is simple, but there are issues to consider in doing so:
- You can invest in a mutual fund or buy an ETF that has exposure to the currency market. These are very directional, and tend to have longer-term outcomes, while perhaps creating unwanted risk exposure to other asset classes, or counterparty risks.
- You can open an account with your broker and attempt to trade the currency market. Recently, the growth of retail interest has been phenomenal. Unfortunately, unless you are prepared to devote your day (and night) to following events you will probably lose money. I believe that the average retail client in currency loses money 80 percent of the time – not because the market is rigged, but because there are so many dynamics to consider when making a trading decision, that only a professional can survive.
- You may place your money with a hedge fund that actively trades currencies. There have been some recent success stories as to how certain managers cleaned up on the short yen trade. Hedge Funds however will generally not provide liquidity due to extended investor lock up periods.
- You should consider opening a managed account which hands the trading duties to a professional trader, while keeping your assets safe in a bank or broker of your choosing. In this way, you benefit from the skills of a professional – just like any other managed investment; you retain liquidity, you have total transparency, and your core assets are protected. A good currency manager should be able to generate returns that match or exceed other traditional investments, on a net basis, especially taking into account the volatility targeted. A professionally selected grouping of currency managers is a new alternative that spreads risk and should be given serious consideration either as a standalone investment or as an overlay to another asset class such as fixed income.
We know that the world of investing is a dangerous arena, where the relationship between risk and reward has fluctuated wildly for many years now, especially in ‘safe’ traditional asset classes.
The currency market by its very nature (Long some- thing/Short something) offers a non-correlated investment to those traditional classes, because profits can be generated regardless of whether equities, bonds, or commodities are rising or falling. In recent years, protection against risk has become the theme for many. There are two ways to reduce risk: Keep your money in cash, or spread your investment allocations so as to be able to earn returns even when traditional asset classes are falling. In my view, a properly managed allocation to the currency markets does just that.
We wish all readers successful investing, and as few sleepless nights as is possible – leave those to the currency traders.
About Ross Taylor
Ross Taylor is a Member of the Board of Directors at Absolute Return Strategies, a CFTC and SEC registered company. He is responsible for the development and monitoring of FX Alpha programmes for Pension Funds, Family Offices, Wealth Managers, Insurance Companies and Private Banks. He has more than 40 years of FX market experience with leading US and European banks.
Please find more about currencies in altii's FX Special
In altii's FX special, asset managers explain in videos and texts how trading the FX markets works and what benefits investors can expect from treating currencies as an asset class. altii has updated the FX special with the latest thinking on selected curriencies and consultancies give their advice on hedging currency risks.