Playing with fire

23 November 2009 | By Rodrigo Amaral, Fund Strategy contributor

Do you remember the good old days when almost any Briton could feel like the king of the hill in France or Greece? All those wonderful Mediterranean meals washed down with a bottle of vintage wine and costing the same as a half-decent fish and chips back home. And the beachfront houses? It was hardly necessary to arrange a mortgage loan to buy a property in the Costa del Sol, and you would only take one because the bank manager would have insisted on it. Beautiful, sunny, civilised and, especially, cheap. What better place to spend your retirement years than in southern Europe?

It feels like a century ago. But in reality it was still possible for British pensioners to live comfortably in Spain or Portugal as recently as 2007, thanks to the strength of the pounds they were holding in their bank accounts in Britain. In January that year, £1 was enough to buy €1.5. It looked too good to be true. It was too good to be true.

Two years on, at the beginning of 2009, the pound was almost at parity with the European single currency. Add in bank transfer fees, credit card interest and the miserable rates banks pay for small currency conversions, and many people were spending more than £1 to buy a single euro. No wonder so many expatriates have suddenly rediscovered the delights of spending their twilight years in Southend or Margate.

The hard luck faced by British pensioners in Europe in the past two years illustrates the risks of dealing with different currencies, and of trying to take advantage of the strength of a particular exchange rate for long periods of time. In a world where most of the main currencies float according to the whims of the market (one important exception being the Chinese renminbi), investors would be well-advised to pay attention to currency risk. Not least because that traditional haven for times of uncertainty, the dollar, looks much less of a safe bet than in previous years.

”As long as we see equity markets rallying, the dollar will keep sliding too”

An old trick of international investors has always been to buy dollars and get rid of other assets once they spot trouble in the financial markets. As tricks go, this is not a very sophisticated one, but it has often worked. Bonds issued by the American Treasury, albeit delivering flimsy returns, are seen as almost free of default risk. Besides, they have always helped to minimise the risk of losing money by the sharp devaluation of some other currency.

The reason is simple: as markets turn unruly, the herd reaction of the investment community is to move to the dollar, boosting its value against other currencies as a result of the increase in demand.

With the American economy being the biggest and most dynamic in the world, the dollar has become the single reserve currency of the global economy. Central banks around the planet stuffed their coffers with the greenback as they planned for a rainy day, and for long relied heavily on dollar operations in the international markets to support their own currencies when they needed to move up or down.

That was before people started to talk about subprime mortgages, Lehman Brothers and credit default swaps as if they were the Knights of the Apocalypse. Since the start of the global financial crisis, the dollar has gone through times of volatility owing to the perceived weaknesses of the American economy—including poorer prospects for GDP growth than before, high unemployment rates and a swelling public deficit—and the powerful medicine applied by the Federal Reserve to try and buck the trend.

The Fed, as well as other central banks, has adopted a low interest rate policy allied to quantitative easing, which is a more credible way of saying that it is pumping money into the economy. With interest rates at almost zero, Treasury bonds look like an unappealing alternative for investors. As soon as markets began to rebound in March, many rushed to sell their greenbacks and buy riskier assets like equities, corporate bonds or gold.

”The UK has a pretty open economy, with nearly 50% of its activity being generated by exports and imports”

Since then, the dollar has been on the slide. And a dramatic decline it has been too. The dollar has fallen by 16% against the euro and 14% against the Swiss franc, although the economies of the eurozone and Switzerland have hardly shone in the same period. Against currencies of better performing economies, like commodity producers, the fall has been much more significant. The dollar has declined by about 30% against the Australian
dollar and the Brazilian real - a rising star in the currency markets.

The signs are that the greenback is still some way from reaching the bottom.

“In the long run I think the dollar will depreciate further,” says Thomas Suter, the chief executive officer (CEO) of Quaesta Capital, a Swiss-based asset manager that specialises in the currency markets. “As long as we see equity markets rallying, the dollar will keep sliding too.”

Analysts note that the dollar has been treated by the market as a funding currency, making viable ever more daring operations as aversion to risk decreases. A typical case is the so-called carry trades, whereby investors use dollars to buy currencies that pay higher rates, like the Australian dollar or the Norwegian kroner. The central banks in those two commodities-producing countries have increased their reference interest rates to prevent their economies from over-heating.

Carry trade operations amount to an explicit bet by investors that the dollar is not going to increase in value any time soon. That is because, if the greenback appreciates, they are likely to lose money at the time of paying back the original dollar loans. A profitable transaction requires that the dollar loses further ground or at least remains at its current lows. The confidence that this is exactly what is going to happen derives to a great extent from the expectation that not much is likely to occur that will prop the dollar up. “I don’t think the US government has any strong opposition to the depreciation of the dollar, as it is helping the economy to recover,” remarks Suter.

Click here to view larger version

A weak dollar helps to fight inflationary pressures by making imports more expensive. It also gives a competitive edge to American exporters, who have an important role to play in the country’s economic recovery as it tries to reduce its dependence on domestic spending boosted by debt.

Tim Geithner, the American Treasury secretary, recently emphasised that “it’s very important for the US and the economic health of the US that we maintain a strong dollar,” but not many people believe his heart is in it.

Colin Harte, the manager of the Baring Global Bond Trust fund, says the dollar will be the victim of “benign neglect” by the American authorities, and low interest rates could remain the rule even well into a period of economic recovery. “They could keep lax policies for longer by mistakenly believing the economy has not recovered, or because they want to generate some inflation in order to erode levels of debt,” he says.

”It is very difficult to tell when and by how much the yuan will appreciate”

This is good news for British pensioners who chose Miami instead of Marbella to enjoy their retirement, as even the pound has gained more than 17% against the dollar since March. But the consequences for almost everyone else are more complicated, and often much less positive.

Authorities and business leaders in the eurozone and other parts of the world - from New Zealand and Switzerland to Thailand and other emerging markets - have been vocal on the need for the dollar to stop falling. Brazil has even created a new 2% tax on short-term foreign investments getting into the country in a bid to slow down the appreciation of the real against the American currency. That is because currencies are weak only in comparison with other currencies.

The positive effects of a weak dollar for the American economy are felt by its trade partners in the opposite direction. Take Europe as an example. A much stronger euro compared with the dollar means that eurozone companies find it more difficult to export to one of their main foreign markets. They also have to face the competition of American products made with lower costs. As the eurozone is also struggling to recover from a sharp economic downturn, a dollar on its way down is not good news for the region. That is the price the eurozone is paying for entering the crisis in a better fiscal position than America.

It is even worse news because the dollar, when it falls, brings on its tail several other currencies whose governments promote policies to keep them close to the greenback. That is what happens with many national currencies in Asia - a region that provides several sources of strong competition for European companies. The renminbi, for instance, has made no gains against the dollar despite the fact that China was one of the first economies to shake the crisis off. Foreign money is flooding the Chinese economy but the renminbi has lost a little ground to the dollar since March. The renminbi does not float freely in the market, with the Chinese financial authorities preferring to peg it to the American currency to maintain the competitiveness of Chinese products. With the exchange rate going down, this competitiveness is increasing. These are tough times for exporters trying to get business back to full steam with costs in euros, which have gained 17% against the renminbi since March.

“The yuan [renminbi] has appreciated against the dollar in the past few years, but the changes have been very slow, and the appreciation has taken place only against the dollar,” Suter points out. “It is very difficult to tell when and by how much the yuan will appreciate,” says Werner Eppacher, the head of foreign exchange at DWS, in Frankfurt. The pressure is on, as governments, business people and international organisations hint to the Chinese that the time has come to let the renminbi go up to help the global economy to find a new, much needed balance.

America’s president, Barack Obama, has made a careful point on the subject, but the American position reflects the difficulty of trying to synchronise exchange rates so that everybody is happy. With China funding a big chunk of the American deficit, the Obama administration can not go much beyond making sensible remarks on the need to let the renminbi find a market price.

Recent admonitions by the International Monetary Fund (IMF), which stressed that the renminbi was “significantly undervalued”, the European Central Bank (ECB) or the governments of other emerging markets will have impressed Chinese policymakers even less.

”The Chinese don’t think in quarters, they think in decades, and they don’t like to be pushed by the market”

“The Chinese don’t think in quarters, they think in decades, and they don’t like to be pushed by the market,” Eppacher says. “They will not let the ECB, the Fed or other central banks tell them what to do.”

A weak dollar and renminbi pose many challenges for the recovery of countries like Britain or the eurozone, and for emerging markets with newly-empowered currencies, like South Africa and Brazil, to achieve sustainable growth. In a recent Surveillance Note, the IMF emphasised that, for all its devaluation, the dollar remains “on the strong side” of its medium-run equilibrium in real effective terms. That seems to indicate that there is still room for further devaluation, although it is not clear that the fall will take a shape set to benefit an international economic balance.

Ken Dickson, the currency investment director at Standard Life Investments, notes that the ideal situation for the global economy would be that the dollar loses value against emerging market currencies, especially in Asia, while appreciating against the euro, the pound and other rich world
currencies. “It is hard to achieve that,” he acknowledges.

Playing the currency market therefore is not an easy task, as much uncertainty lingers concerning the future of the main economies. At present investors seem confident that the American, European and British central banks will stick to their loose monetary policies, keeping low interest rates and pumping extra money into the economy. They are taking advantage of this situation to bet on equities and corporate bonds, but many are looking into higher-yielding currencies too.

Not many options, however, can be found in the market. Dollar depreciation investment strategies are limited to the euro, the currencies of commodities-exporting countries like Australia, New Zealand or Norway, or those of emerging markets doing well despite the crisis, like the Polish zloty, the South African rand or the Brazilian real. Some analysts say that it is not possible to say what will happen to the Japanese yen, another possible alternative.

There are grounds, though, to expect the pound to regain some of its shine. “The UK has a pretty open economy, with nearly 50% of its activity being generated by exports and imports,” Harte says. “To have a very weak currency would imply inflationary pressures very quickly.” Therefore, it is not a wholly improbable assumption that the Bank of England will tighten its monetary policy earlier than its American counterpart.

Much relies, however, on the broad and shaky shoulders of Britain’s banks. “The British economy is very dependent on the financial sector,” Suter points out. “If the financial markets continue to recover, the pound should get support from investors. If not, it will get hurt.”

Better alternatives might well be found much further east. “We have a lot of our bets towards Asian currencies,” says Dickson. “Currencies like the Korean won remain 20% lower against the dollar than in September or October last year, and the yuan has depreciated strongly against the euro and the yen.”

Other analysts say that the Chinese government will let the renminbi go up in the next 12 to 18 months as it faces the risk of seeing the formation of several asset bubbles in the economy fuelled by the alliance of a cheap currency with a strong inflow of foreign money. Although it is hard to get hold of renminbi as they are not freely traded in the market, experts say it is worth ­making an effort on a long run outlook, and the same goes for other Asian currencies.

”There still are a lot of investors, especially in the Anglo-Saxon world, who are not sure whether the euro experiment will be a success”

“In a long-term horizon, you have to be long in Asian currencies against the dollar,” says Eppacher.

Of course, you can say many good things about international investors, but probably not that they are very brave when it comes to their own money. People may not love the dollar today, but the real test of whether the greenback has lost its shine will only come when international markets begin to crumble again. Other currencies, like the euro, have made inroads in the reserves of central banks, a sign of safe haven status, but many analysts still expect that the dollar will once again be the choice of fleeing investors the next time risk aversion goes up.

“There still are a lot of investors, especially in the Anglo-Saxon world, who are not sure whether the euro experiment will be a success,” says Eppacher. And the sentiment of the market tends to vary wildly with the economic data too.

“Six months ago, there were all these discussions about Greece, Ireland or Italy leaving the eurozone, which were complete nonsense,” Eppacher recalls.

“But they showed how fast investors can change their minds, from talking about the euro as a new reserve currency to forecasting the end of the eurozone and the euro.”

To protect themselves from such fluctuations, many prefer to reduce the risk by means of derivatives called currency options or defensive currency strategies especially designed by specialist firms.

And you can find several contrarians who say that the best currency to take advantage of market volatility is the dollar itself. Pareto Partners’s Mauricio Bouabci, the manager of the BNY Mellon Evolution Currency Option fund, is one of them. His fund is invested in dollars and he says the bet is going to pay off no matter what direction the market moves in. “There is only one trade in the market today,” he says.

“Investors sell dollars and buy riskier assets, believing that it is a safe bet while interest rates are low.” Consequently, many different markets are moving in the same direction. “As a result, the correlation between different asset classes is too high right now: commodities go up, so do equity markets and high-yield currencies like the Australian dollar. This is a dangerous situation that cannot last forever,” he adds.

In Bouabci’s view, dollar depreciation strategies are only likely to work out in the long term if the economic situation remains unchanged, which is highly improbable.

“At some point, economic data will worsen, and investors will sell risky assets to go back to dollars,” he forecasts. “Or the economic picture will improve, and then interest rates will have to go up. In either case, the dollar will appreciate. The situation is a temporary one, and the longer it lasts, the closer we get to its end.”

Currency options markets already reflect this view, according to Bouabci. “The demand is for buying dollars, and not to sell, and volatility is going up,” he notes. We may find out in the near future that reports of the dollar’s demise have been greatly exaggerated.

Have your say

Please do not complete the following form field for security reasons.

Name

E-mail

Comment

I have read and agree to the terms and conditions