Currency Markets Signal Shift Away From QE Regime

Investors are returning to how they used to trade currencies before monetary guardians such as the US Federal Reserve embarked on bond-buying sprees, according to Hinesh Patel, fixed-income portfolio manager at Old Mutual Global Investors.

Trading macroeconomics via the currency markets has until recently been relatively straightforward ever since the deployment of quantitative easing (QE) in response to the global financial crisis.

Investors looked least favourably upon those countries whose central bankers were hoovering up the most government bonds and other securities. This is because their interest rates declined, tarnishing the relative attractiveness of currencies, and their monetary bases – part of the money supply – expanded.

But of late, and markedly since the start of this year, investors appear to have discarded this framework. The key drivers of foreign exchange rates have become purchasing-power parity (PPP), which takes into account relative price levels in different countries, and current account balances, which measure trade in goods and services and investment income.

This is essentially a return to how investors used to trade currencies, before monetary guardians such as the US Federal Reserve embarked on bond-buying sprees.

The recent strength of the yen against the US dollar demonstrates this shift. Under the old ‘QE regime,’ one would have expected the currency of a country where ever larger amounts of money are being created to buy financial assets to decline against one whose central bank has halted such purchases and even begun, albeit rather hesitantly, to raise interest rates.

Yet the yen has surged in the year to date, amid an increase in Japan’s real interest rates – nominal yields, minus inflation – which feed into PPP; and as its current account surplus has swelled. While of course there are other factors also at work here, we believe these two have been critical in taking the currency to its strongest levels versus the greenback since October 2014.

The weakness in Britain’s current account balance, meanwhile, has been a significant headwind for sterling – somewhat overlooked amid the excitement around the referendum on EU membership in June.

Still, these recent moves in foreign exchange rates should be seen in the context of longer-term trading ranges for the major currencies, which remain broadly intact. What they do suggest, though, is the importance of not being too wedded to any particular model for investing in currency markets.

Across our fixed-income portfolios, we seek to position for a range of scenarios and resist the temptation to adopt a stance that is too dependent on one side of a binary outcome – to avoid being wrong-footed by such shifts as the one currently underway.