Currency wars

by: , Chief Investment Officer and Managing Director | IndexIQ

A July 21st story on Bloomberg put it this way: “the currency wars have arrived.”

Maybe, or maybe not, but clearly currencies are now front and center in the minds of investors, as a further complication in the ongoing trade disputes between the U.S. and its trading partners. Adding fuel to the fire, President Trump recently accused both Europe and China of currency manipulation. Leaving aside the merits of the arguments, these developments go to a point we’ve made before: the difficulty of predicting currency movements over the short-term. Long term, currency relationships tend to be mean reverting, but within the average investor’s time horizon, they can be volatile driven by everything from interest rate policies to political rhetoric.

If nothing else, we appear to have entered a period of heightened uncertainty. Last year saw the dollar turn in its worst performance in 14 years, and many prognosticators expected more of the same in 2018. Through March, those predictions were on target as the dollar fell around -1.75% relative to other major global currencies. But then the rhetoric on trade started heating up and the ground shifted almost overnight. The dollar reversed course. Since April it has rallied substantially, climbing some 6%.1

This short-term unpredictability can be disconcerting to U.S.-based investors, where returns are a function of both local market performance and the translation of that performance back into dollars. For those investing in individual countries, the process is even more complex as each country has its own currency and those currencies often move in different directions relative to both the dollar and to each other. Most recently we’ve seen a decoupling of the dollar with the Euro and the Yen, with the former down and the latter up. The Chinese yuan has its own dynamics, as do the currencies of the more than a dozen countries defined as “emerging.”

Central bank efforts at normalization matter, too, and different countries and regions are at different stages of the process, impacting currency strength. Managing these risks is complicated. While those who are willing, and able, to wait out the volatility will likely do just fine, many will start to move money around in response to the dislocations caused by the currency “wars,” destroying value in their portfolios. Both fully hedged and fully unhedged positions can expose investors to unexpected twists and turns, to say nothing of increasingly unpredictable political events. For many individuals, there’s a good chance of being wrong directionally over their investable time horizon.

A diversified ETF offers a way to address these issues. It can eliminate the need to manage individual currency relationships while providing exposure to a broad range of countries and industries. It also provides the opportunity for more creative hedging. For example, we have long been proponents of a 50% hedge, which serves to dampen currency-based volatility while removing the need to take a strong view on currency direction.

A full-blown currency war may or may not be on the horizon, but all the heated talk around trade appears likely to continue for the foreseeable future. The last six months have demonstrated yet again how hard it is to predict how markets will react. Maintaining a 50% hedged currency position can help investors stay with their plan through these uncertain times.

1. Source: UUP ETF, as of 3/31/2018.

About Risk:

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Salvatore J. Bruno

Chief Investment Officer and Managing Director | IndexIQ

Sal is Chief Investment Officer at IndexIQ, where his primary responsibility includes developing and maintaining the firm’s investment strategies. Sal joined IndexIQ in 2007 from Deutsche Asset Management (DeAM) where he held a number of senior positions

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