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