Monetary Policy Divergence and Developed Currency
It’s Spring Break! Families and students alike are traveling worldwide. We thought this Market Chatter was a good time to discuss the market dynamics for currency—and oh yeah, given the recent news from the ECB, it’s a newsworthy topic too! The sheer number of variables that impact the supply and demand for currency makes forecasting currency appreciation or depreciation challenging. To tackle this challenge, we can use simplified economic models to help us frame real-world events. Like any well laid plan, however, moves by market participants (and even non-suspecting globetrotters) can derail our models and result in outcomes different from our expectations. In this Market Chatter we will review 1) a framework for forecasting exchange rates, 2) how recent market actions have impacted exchange rates, and 3) what NEPC believes is a viable option for most portfolios to limit the impact of these variables on returns of your non-US developed market currency exposure.
Monetary and Fiscal Policy
While it is very challenging to address a nuanced topic like a multi-currency exchange rate environment in two pages, we’ll attempt to reduce complexity by focusing on monetary policy because of the headlines since the Financial Crisis. However, later in the year, you can bet a Market Chatter will provide you with a recap of the Presidential election and what it means for fiscal policy. We will, also, avoid the subject of Britain leaving the Euro (“Brexit”) and the impact it has had on currency markets. While it, like the presidential campaign, is a fascinating and relevant soap opera to watch, it may require a separate piece entirely.
If a country or central bank decides to shift to a more expansionary monetary policy – and that shift is unexpected – the economic consensus is that real rates (nominal rates minus inflation) decrease. This is what is referred to as “easy money”, as the Central Bank tries to restart the economic engine by making the interest rate on loans attractive to companies and consumers. As a result of the decreased real rate of interest earned, investors will pursue investments returning a higher real rate elsewhere. The demand for the local currency will decrease. Why? Money leaves the low rate country and moves to the higher rate country. To do that, investors sell the low rate country’s currency (downward pressure) and buy the higher rate country’s currency (upward pressure). Assuming the money supply is held constant, the expansionary monetary policy will lead to a depreciation of the local currency relative to the foreign currency. This is what happened in the third quarter of 2014 when the US Federal Reserve began winding down the quantitative easing program (increasing rates) and the ECB announced details of its asset purchasing stimulus program (lowering rates). During this time period, the US was now beginning to tighten – or at least take its foot off of the gas pedal – while the rest of the world continued to ease. As a result, the US Dollar dramatically increased its pace of appreciation relative to other major currencies. As shown in the chart on the prior page, the MSCI EAFE Index (a broad developed equity index) in local currency terms began to outpace the MSCI EAFE Index based in USD during the third quarter of 2014 due to the strengthening US dollar.
Now with the ECB’s and Mario Draghi’s announcement on March 10, 2016, that the European Central Bank didn’t “anticipate that it will be necessary to reduce rates further” the markets, somewhat surprisingly rallied and the Euro slightly appreciated relative to the US Dollar in the following days. Why? According to the Wall Street Journal it is because “investors reassessed” the ECB announcement. Said differently, markets were expecting easing measures beyond an expansion of QE and when those measures were not announced, investors changed their expectations.
What makes this thought process challenging is that we can’t hold variables constant in the real world. One country may adjust their monetary policy while another country makes simultaneous decisions. Economic theory tells us that the relative difference between changes in interest rates and inflation rates are the primary drivers of currency appreciation and depreciation. Experience tells us that, in addition to these factors, market participants make investments in anticipation of announced changes to interest rates or inflation levels causing markets to behave differently than our simplified model would indicate at the time an announcement is made.
What does this mean for your portfolio?
While the markets continually reassess investments and try to forecast where economic variables are headed, NEPC believes there is a different approach which may sidestep some of the volatility. We recommend implementing a 50% developed currency hedge for most client portfolios. Historically, developed foreign currency exposure has added volatility to a portfolio without diversifying risk or adding to expected return over time. Over the last twenty-five years, developed market currency risk has gone uncompensated. We don’t recommend a full currency hedge because a risk analysis shows that beyond a 50% hedge the risk reduction benefits decrease.
In this Market Chatter piece our simple currency framework is supported by economic theory, however theory is not always reflected in reality. Markets act as a discounting mechanism by anticipating future government and central bank actions but currency markets may experience a significant amount of volatility. Given this is considered uncompensated risk, based on our analysis, we recommend a 50% developed currency hedge for many investors.
Disclaimers and Disclosures
- All investments carry some level of risk. Diversification and other asset allocation techniques do not ensure profit or protect against losses.
- The opinions presented herein represent the good faith views of NEPC as of the date of this paper and are subject to change at any time.
- All investment programs have unique characteristics and each investor should consider their own situation to determine if the strategies discussed in this paper are suitable.
- This report contains summary information regarding the investment management approaches described herein but is not a complete description of the investment objectives, portfolio management and research that supports these approaches.