A Deep Dive into Currency Volatility
by William Sapphire
Zooming in on the Importance of Currency
As investors, we often give far too little thought into currency fluctuations. I personally can attest to it – compared with tracking index performance and stock picking, currency movements is probably the last thing I would look at every morning. However, currency does have a significant impact on investing.
I was intrigued by the dramatic changes in household wealth published in Credit Suisse’s Global Wealth Report 2014-2015. It seemed countries that had the highest household wealth losses were also the ones with the highest currency devaluation (Ukraine, Russia and Brazil), while countries that had the biggest gains benefitted from the US dollar rally (Hong Kong, China, Saudi Arabia – whose currencies are more or less pegged to the US dollar).
Currency risk is increasingly important as our nest eggs increase and activities becomes increasingly global. Several days ago, an international friend told me that one major reason why he chose Rotman, on top of it being a great school, was the fact that the US dollar rally had made the US alternatives so much more uneconomical.
In large part, many currency devaluations last year were caused by a weaker Chinese economy and sluggish raw material prices. A significant number of countries depend heavily on resource exports as a percentage of their GDP. As prices of these resources fell, countries’ local currencies also faced lower demand in facilitating the transactions, putting downward pressure on local currencies.
Russia, Ukraine, Brazil, South Africa and Canada are all countries who are relatively dependent on the resource sector compared to the US, making them more prone to demand shocks from a commodity market trough.
Diverging Economic and Monetary Policies
Traditionally, the US dollar, the Swiss franc and Japanese yen were considered safer currencies given the liquidity and strength of the underlying economies. Past year’s movements tells a different story, however, as investors rallied to US dollar based on stronger economic recovery and interest rate hike expectations. Compared across the major currencies, US is the only economy with rising interest rate expectations in 2016, while Canada, Japan, Eurozone, and Switzerland plan to either keep the same interest rate level or move into negative yields. While there is no way of telling how long the strengthened dollar will continue on its course, the monetary policies across multiple central banks will likely continue to play an important role.
An Era of Increased Currency Volatility
Compared to previous years, currency volatility rose significantly in recent years. JP Morgan’s Global FX Volatility Index indicated high levels of interest rate risk expressed in options prices. On the other hand, a WSJ article in September 2015 also stated that currency volatility cost companies more than it had in the past three years.
Given the importance currency plays in our financial portfolio, we can choose to manage our currency risks by design, or let it fall prey to external shocks by default. Potential considerations for mitigation strategies include shifting currency exposure away from cyclical, resource-based economies, or having a balanced currency exposure based on intended usage of the fund. Regardless of whether you are from US, Canada, or China, in the age of increased currency volatility, it is ever more important to diversify across multiple currencies.