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Axel Merk and Michael Cirami

As recent currency fluctuations show, investors need a plan to deal with risks.

Anthony D'Asaro, 04/20/2015

Currencies have stolen the spotlight as of late. In January, the Swiss franc revoked its peg versus the euro and appreciated more than 30% in one day. Japanese Prime Minister Shinzo Abe vowed to depreciate the yen as part of his plan to lead Japan’s economy back to growth. The euro faltered on renewed instability in Greece. On March 2, the U.S. dollar index hit an 11-year high, after more than a decade of slow declines. These events reflect the intentional and unintended consequences of unprecedented central bank stimulus programs that have persisted in the aftermath of the Great Recession.

Morningstar asked portfolio managers Michael Cirami and Axel Merk to give us their insight into current events surrounding the currency markets and how investors should react to them. Cirami, CFA, is co-director of the Eaton Vance Global Income Group, which manages a full suite of international bond, emerging-markets bond, and currency strategies. Merk is the president and chief investment officer of Merk Investments, a currency-focused boutique that includes hard currency and currency overlay strategies and the Merk Gold ETF OUNZ. We held our discussion on March 2. It has been edited for clarity and length.

Currencies seem to be a mystery to most investors. Prices seem to move for reasons that people cannot understand. How should investors look at currencies?
Axel Merk: One way to look at currencies is that everybody has currency risk. Even when you’re a U.S. dollar-based investor, especially with negative real interest rates, you are at risk when you’re holding cash. When you invest internationally, you have currency risk. So, it’s a good idea to try to understand what’s occurring.

Let me list two ways one can do that and then have an investment strategy that applies them.

First is from a macro perspective. Most people would agree that central banks have been influencing asset prices. Well, the place where you might see it first is the currency markets. If there’s one good thing to be said about policymakers is that they’re predictable. So, if you think that you know what Mario Draghi or Haruhiko Kuroda or Janet Yellen is up to, that might guide you in the currency space and in the markets in general.

The other way to look at it is simply from a risk-management side. As I mentioned, everyone faces currency risk. Well, it turns out, just like in the equity markets and other markets, there are measures of risk that are in the market. Specifically, if you look at the options market, you have measures of implied volatility, which is a very good measure of risk.

What’s unique about the currency markets is that you have professionals on one hand who deal in things like options. Then, on the other hand, you have corporate hedgers, central banks, and tourists who all deal in currencies without trying to necessarily maximize their profits.

What happens is that the professionals have a leg up in the market. These risk measures tend to reflect changes in sentiment in the markets before it trickles down to everybody else. If you have a risk-management strategy, you can be a step ahead of the market, to not only mitigate your risk but to actually make money.

So, both from a risk point of view and from a macro point of view, I think there are lots of opportunities in the currency markets. There is a real need to be able to manage risk and, obviously, to try to make money.

Is it possible to predict the direction of currencies?
Michael Cirami: I think making predictions for any asset class is always challenging. The framework to use for currencies, or at least that we have here at Eaton Vance, is that currencies like economic growth and the high interest rates that come with it. So, for us to develop our views on FX, we focus on country analysis— specifically, macroeconomic and politics—in trying to get an understanding and view of what types of policy changes are coming down the pipeline. Then, we ask, how will those policies have an impact on economic growth? So, it’s economic-model driven in trying to predict growth rates.

Now, when thinking about predicting currencies, there’s a direction, but then there’s also the level. If you think a currency is going to adjust from one level to another, what level does it need to move to? That’s a bit trickier. We use economic data as our guide for that. I think you can see in the economic data when currencies have found their appropriate level.

Merk: If I can just add to that. There are many myths in the currency space, and one is economic growth. Growth works for some currencies, but it doesn’t apply to all the currencies. The Japanese yen is the best example of why growth isn’t a predictor of a “good currency.” In fact, the worse Japan has done economically, the better the yen has been doing. Similarly, I would even allege that the euro is not driven necessarily by growth. The euro can be quite strong with lackluster growth.

So, one has to look at other dynamics that help shape what drives the currency. For emerging markets, I would be on board with growth being one of the key drivers. But different currencies have different dynamics. One has to be careful in applying a broad brush to the entire market.

What dynamics are affecting the U.S. dollar? Why has it been so strong recently, and why has that come as a surprise to people?
Cirami: I’m not sure why the dollar caught people off guard. To me, it seems like it’s clearly reflecting divergent monetary policy and the expectations of that between the U.S. and Europe, primarily the European Central Bank, and between the U.S. and major Asian central banks—China and Japan.

The timing of this divergence has been a bit uncertain, but I think it’s been pretty well telegraphed on both sides that it’s coming. So, I think the dollar strength is largely a reflection of that. When will it end? It’s going to be difficult to know when and what the level will be of various exchange rates at that point.

But clearly what one needs to watch is monetary policy in the U.S. and the other major central banks. Then, we should be looking at the economic data, primarily out of the U.S., to see how the U.S. economy is coping with the stronger dollar and how the corporate sector, in particular, is responding, as well.

Merk: A reason why the dollar has been strong is precisely because the expectation is that the monetary policy is going to be tight in the U.S. I’d like to caution, though, that if you look at inflation numbers around the world, a currency often ticks up when inflation moves up. That sounds counterintuitive, but the reason that happens is because the expectation is that the central bank will do the right thing and tighten monetary policy.

The proof, however, will be in the pudding, whether the central bank can actually follow through, because any gain in the currency can also be lost again. If you take the example of the U.S., yes, the dollar has been rising on the expectation of rising U.S. dollar rates, but let’s keep in mind that we haven’t raised rates yet. In fact, Yellen in the FOMC statement all but promises to be late in raising rates by saying that, even as inflation picks back up, that monetary policy will probably be more accommodative than it would be during other times.

That then brings me to another way of looking at the currency markets. If one doesn’t just look at it from an economic point of view but from a market dynamics point of view, the U.S. dollar has a reputation of rallying in a risk-off environment. In 2008, the U.S. dollar was very, very strong, for example. But since last summer, the dollar has been rising against the backdrop of a rising stock market. To me, that suggests that one of the key reasons why the dollar has been rising is because foreigners are buying U.S. dollar-denominated assets. That conversely may mean that if there’s a risk-off environment, that foreigners might be selling their holdings, where they’d be repatriating their money.

So, when the dollar rises in a risk-on environment, don’t count on the dollar also benefiting in a risk-off environment. A lot of good news is priced into the dollar, and we have to be a little bit cautious when everybody says the dollar is going to go up.

Cirami: Broadly, I agree with that. I would just add that there are various ways to tighten monetary conditions in a country, and a strong currency is one of those ways. Now, it’s a bit strange to talk about currency as being a way to adjust monetary policy in such a large economy as the U.S., particularly one that’s not as open as countries that are much smaller. But I think it’s clear that the monetary conditions in the U.S. are going to tighten, and it’s going to play out in various ways through policy-rate moves, which are going to come at some point in time. Currency strength will be another way. So, the more currency strength we see, it might actually push out rate movements into the future. If we get a weaker dollar from here, it might prompt the Fed to move quicker.

So, these things will be like a dance, going back and forth, in the marketplace. Ultimately, it will get resolved, probably with a bit of a stronger currency and higher rates, but that’s going to take some time.

Merk: I agree in theory, but not necessarily in practice. If you take a currency like the Australian dollar, yes, very much, a strong Australian dollar would tighten monetary policy and would help the central bank from tightening less. The reason I disagree with it in practice in the U.S., aside from that the U.S. is a more closed economy, is that the folks who actually make the decisions at the Fed appear to be pretty aloof about the strengthening dollar. I don’t really think that they will take it into account in their decision-making until corporate America is complaining much more strongly than they have even now. Yellen, in particular, seems to be so focused on the labor market that she might not notice the strengthening dollar causing headwinds until she’s already made decisions otherwise.

To Hedge or Not to Hedge
Given all that we know about the dollar, does it make sense to hedge your dollar exposure at this time?
Merk: Investors have currency risk, especially when they’re internationally invested. About 30% to 50% of a daily move in the equity markets is due to currency moves. Now, if you take out the currency risk, my view is that you’re leaving chips on the table. My view is that investors should really think about it in terms of allocating a risk budget. When you invest internationally, you have allocated a risk budget to currency risk. Do something prudent with it—actively manage that currency risk. Rather than leave it in there or take it out, manage it actively. As I indicated, yes, the dollar might be rising, but there’s absolutely no guarantee that it’s going to continue to rise.

Cirami: When I think about the question of whether one should hedge or not hedge their dollar risk, one of the things that it makes me think about is the average household and their asset-liability mix. So, if you think about all the things that a household might consume as being their liabilities, they do have exposure to currencies. They’re importing goods from various parts of the world, and through that sort of arrangement, you have FX exposure.

Then, when you move to the asset side of a household’s balance sheet, there’s very clear home bias in the U.S., where the predominant weight of the assets that are being held by households are assets in the U.S., denominated in U.S. dollars.

So, thinking about that potential mismatch is a worthwhile exercise for households. If you say necessarily have to play that by being essentially short the U.S. dollar.

Investors see the headlines that the U.S. dollar index has reached new highs. But they forget that the dollar index is the U.S. dollar versus other currencies on the other side. The euro has a 57% weight in the U.S. dollar index. So, the story may not be so much the U.S. dollar index rising but that the euro has been weak. What’s happening in the eurozone?
Cirami:
It’s complex. Before the eurozone, ndividual countries had interest-rate risk and they had currency risk, because they had their own currency. Obviously, with the introduction of the euro, the currency risk seemingly went away. But risks don’t just get eliminated; they get transformed. Now, it’s credit risk. For a long time, the markets priced in zero credit risk. At the same time, a number of countries’ creditworthiness deteriorated.

So, today, we are in a difficult situation. You have a monetary system that might not make a whole lot of sense, because a number of countries are probably not solvent. This needs to be worked through, and the way that it’s being worked through is by papering over it with monetary stimulus of various forms from the European Central Bank. The hope is to inflate away the issues and distribute the losses, rather than have repeated credit events.

Merk: Broadly speaking, there is a monetary component to the eurozone story, a fiscal component, and then maybe a tail-risk component.

Let me start with the last one, because I think it is given a little bit too much emphasis—the tail risk of Greece “blowing up” and the like. We do know the playbook of central banks in a crisis these days. We also know that most of Greek debt is held by the European Central Bank, by the European Union and by the IMF, as well as by some hedge funds. Very little debt is held by financial institutions.

As a result, the “contagion” that would come out of Greece—defaulting, restructuring of possibly even the euro—is less severe. The market has been less nervous about that event, and the euro has been comparatively strong in that sort of environment despite the risks that are considered by some people to be very severe risks.

Now, as far as monetary policy is concerned, last summer, Draghi decided that he needed to do much more. The key goal that he most likely has is to specifically weaken the euro. The idea is that a weaker currency allows inflation to inch up a little bit and allows Europeans to export a little bit more. The problem, of course, is that the issues in the eurozone are not of monetary nature. They’re structural, and these sorts of things are not being fixed with cheap money. In fact, the folks that benefit most from the lower euro are the folks that are ready and able to export—Germany, in particular.

At the same time, at the other end of the spectrum, the risk going forward is that, now that QE is going to be implemented, how much is that going to weaken the euro? In the U.S., when QE actually started, the dollar started falling. So, again, there is no assurance that the euro will fall. What makes QE in the eurozone unique is that banks can’t simply sell their securities and park them with the European Central Bank because there are negative interest rates for cash that’s parked at the ECB. Then, conversely, it’s not even clear that institutions want to sell their bonds. The debt markets are far less liquid in the eurozone. So, there’s a lot of execution risk here. I think that is one of the bigger risks to the euro right now.

So, it seems like you think quantitative easing is not going to be effective in the eurozone. Mike, do you agree with that?
Cirami: Well, I struggle with answering that question because I’m not sure what success looks like for quantitative easing in the eurozone.

If the goal is to rejuvenate growth, then I think it will be unsuccessful. If the goal is to weaken the currency, then I think we’ve already seen some success through announcing the program, and I expect that we would see some more success. If the goal is to generate some inflation, then I think there’ll be some mild success when compared to a counterfactual that we won’t know for sure what inflation would have been like without having the program, but probably not enough inflation to make a difference. So, if I think of those three things as the goal, then it’s a bit of a mixed bag.

Another goal of quantitative easing is to prevent the tail risk from happening. I am a bit more concerned about a tail-risk event of a country leaving the eurozone. I expect it to happen at some point in time. I just don’t know if it will be in the investable time horizon. But all good things come to an end, and I’m fairly confident that the eurozone will as well. But if one of the goals is to keep that together for the time being, then I think QE will have some success there in eliminating one of the tail risks.

Merk: I very much agree. It depends on the definition of success. Let me turn that upside down, though, and ask the question, what does it matter if the euro were to break up? The reason I ask it that way is that how does one hold one’s euro? Is it a derivative? Is it a German T-bill or the Greek bond? If you own a German T-bill, then you don’t really care, longer term, whether the euro breaks up or not, because you would just be holding a new deutschmark. The same issue, by the way, happens with other currencies as well. In the U.S., if you own a U.S. money market fund, well, if you dig deeper into the holdings of that money market fund, you might find that the fund holds commercial paper denominated in U.S. dollars, issued by European banks. That is a different dollar versus owning a U.S. Treasury bill.

So, success is in the eye of the beholder. Draghi really would love to weaken the euro. Yes, he has achieved some of that, but if you want to get inflation, that’s very difficult when the so-called transmission mechanism is impaired—when the banking system is not very healthy. What I believe is going to happen is that any inflation will be emanating from elsewhere—notably, the U.S. at some point—and then be exported to Europe. But it’s going to be very, very difficult to induce inflation in the eurozone.

Do these currency wars that the major powers seem to be playing force emerging markets to follow their lead and devalue their currencies as well?
Cirami: It puts pressure on these currencies and policymakers. I think the best approach would be to take it sort of country by country. As an analyst, I think there will be some winners to pick out there. But yeah, it’s going to be a challenging environment for central banks in large and medium-sized emerging-market countries.

You’re seeing some fight back. Israel comes to mind. But we’re probably in the middle innings on this one rather than late in the battle. There’ll be more pressure to come, and investors in emerging-markets currencies right now need to be extremely selective.

Merk: Let me make a broader point. We focus in on the challenges and the solvency issues in the eurozone. But let’s not forget that much of the developed world has related challenges. It’s just that institutionally and culturally they’re dealt with differently. I would think most people would agree that Japan’s debt load is rather enormous. At the same time, they are able to manage it, and the market has been very well behaved.

In the U.S. as well, if we look at our long-term entitlement obligations, we have a very serious sustainability issue. At the same time, the market isn’t concerned at all. The questions then become, well, why isn’t the market concerned and what would get the market to be concerned?

I mention this partially because we have QE in the eurozone, but we have negative real interest rates in the eurozone, Japan, and the U.S. I would allege that that’s going to continue to be in place for quite some time in all of those three regions. That’s going to keep these currency markets very, very interesting for some time to come.

Cirami: I would argue that there are losses in the system in the eurozone and perhaps even in U.S. government bonds and in Japanese government bonds. If you take that view, then what’s left is how do you distribute and administer those losses? I think the market is fairly good at dealing with how to handle losses that come through losses in purchasing power, specifically an inflation. It’s a more challenging environment to deal with losses that come through a credit channel. The reason why is that those are immediate and bring up all sorts of shocks, and one doesn’t really know how it’s going to ripple through the economy.

It’s unclear how those losses will be administered in Europe, whether it’s through a credit channel or inflation, and that’s what has the market on edge. It’s come to a sort of understanding that the policy preference is for the inflation channel. But it’s not clear whether that ultimately will be politically feasible. I think those distinctions are important to keep in mind when thinking about foreign currency risks.

Inflation Strategy
Will the United States have to bring inflation here to solve its fiscal problems?
Merk: That’s going to be the attempt. I think the U.S. is going to be far more successful at it than other countries. That’s what Yellen is all but promising by keeping rates lower for longer. Bernanke always argued for tightening late when you’re faced with a credit bust, so that when you take the foot off the accelerator, the deflationary forces don’t take over again right away.

You want to firmly be on the side of inflation. The problem we have in the U.S. is that a lot of benefits are indexed to inflation, so this only works if the CPI is under-representing inflation. While many allege that it does, that might not be sufficient. But clearly we have a major incentive in the system for inflation. We have a government that has a lot of debt. We have consumers that have a lot of debt. We have foreigners owning that debt.

Having said that, of course, inflation is not the problem of the day. But down the road, there are going to be major incentives in the system for more inflation. The only problem with that is that it’s not a very stable environment. When you have negative real interest rates for an extended period, that will cause some unintended consequences, and that’s going to be tomorrow’s problem that the Fed is going to worry about.

Cirami: I agree. We’re ready for inflation. In terms of an economy and how to deal with some of our problems, it’s just going to be tough generating it in the near term. But that’s clearly the policy preference.

Merk: The question, of course, is it’s one thing for the government to do something, but what does it mean for us as investors? Clearly, if one has invested in risky assets, one has been able to stay ahead of that. But one day, that’s not going to work so well. Stocks are not going to move up; bonds are not going to move up. So, what do you do as an investor to prepare for that sort of environment? There is no easy answer for that. But I do think the currency market is one area where one is able to produce uncorrelated positive returns with a good strategy.

That is why I think investors need to have a toolbox. Just like Bernanke talked about the toolbox, investors need to have a toolbox and be able to deploy those tools to be ready for that sort of environment.

Anthony D'Asaro is a fund analyst at Morningstar.

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