Currency Management is one of the 3 pillars of our active global macro fixed income process, alongside duration and credit. Abdelak Adjriou, Lead portfolio manager for the Carmignac Portfolio Global Bond fund, sees currency management as an important tool to add both alpha and downside protection.
Our 3-step approach to currencies in a nutshell
Step 1: US dollar versus rest of the world currencies
Understanding the USD is our primary focus when analyzing the market from a top-down perspective. We meticulously evaluate several crucial sub-factors that contribute to the overall performance of this asset: the growth differential, the real interest rates impact, and the safe-haven status.
UNDERSTANDING THE GROWTH DIFFERENTIAL FACTOR
The principle is simple: we compare the performance of the US economy to other global economies, to determine the potential impact on the USD.
The USD tends to exhibit a trend-following behavior. Periods in which the US economy outperformed the ‘Rest of the World’ are mid-70s to 85, early 90s to 2002 and the latest period goes from ’11 to date. Consequently, during these same periods, the USD has outperformed the rest of the currencies.
Today, the USD cycle is breaking this 8–10-year pattern mainly supported by the exceptionalism in US growth and the ongoing US fiscal stimuli. Our view is that the turning point from the USD cycle peak may be occurring, but it is certainly expected to be slower than initially predicted, unless there is a sharp US fiscal contraction in the near future.
DOLLAR AS DRIVEN BY REAL INTEREST RATES’ STRENGTH
Typically, the relationship between the "growth differential" and the real interest rate differential is closely intertwined. However, there are instances when this connection breaks, and the sole indicator of the dollar's trajectory becomes the real interest rates. Hence this element too has an important role in our process.
THE USD AS A SAFE HEAVEN
During recessions too, the USD value tends to rise as it serves as a safe haven. This dual role of the USD, as a growth proxy and a safe haven, is attributed to its status as the world's primary reserve currency and the stability of the US financial system.
Step 2: Creating alpha through bottom-up currency selection
SELECTING EMERGING MARKET CURRENCIES: TRADE BALANCE DYNAMICS ARE KEY
Emerging market currencies are influenced by fundamental and technical factors that shape their value such as real interest rates and current account dynamics. One of the most important factors is the flow of money into a country from abroad, monitored through the current account and more specifically the trade balance. A positive and expanding trade balance, indicates more exports than imports, leads to money inflows and strengthens the currency of a country.
As of today, we have a positive outlook on the Chilean Peso in our Global Bond strategy, primarily due to its significant growth and positive dynamics in its Current Account/Trade Balance. Chile has consistently recorded trade surpluses since 1999, and its growth dynamics have been particularly strong since 2022, largely driven by increased copper shipments. Another currency that exemplifies the relationship between Trade Balance dynamics and currency valuations is the Polish Zloty (PLN), as depicted in the chart above. Therefore, our key takeaway is the importance of considering trade balance and current account dynamics in conjunction with currency valuations.
SELECTING DEVELOPED MARKET CURRENCIES: FOLLOW THE MONEY!
Developed market currencies on the other hand, are influenced by growth, real rates and specifically the dynamics of financial accounts, another sub-account of the balance of payments. That, for instance, means that countries with higher real interest rates may attract bond investors and capital, leading to a positive impact on their currency valuations. Additionally, countries with attractive and performing stock markets tend to also draw capital, further bolstering their currency. For example, in the 1990s, the Swedish Krona experienced a remarkable appreciation due to Sweden's stringent monetary policy aimed at combating inflation. This resulted in higher interest rates compared to other G10 countries, attracting a significant influx of capital, and sparking the appreciation of the Swedish Krona.
Step 3: Currency valuations
When it comes to assessing currency valuations, we utilize various models to determine the relative strength or weakness of a currency. One commonly used model is the Real Effective Exchange Rate (REER), which compares a country's currency to the currencies of its trading partners, considering inflation. This analysis helps us determine whether a currency is overvalued or undervalued.
Another model we consider is the Purchasing Power Parity (PPP), which compares the prices of goods and services between countries to determine the fair value of a currency. This valuation model is particularly effective in extreme scenarios, where a currency is over or under valued by more than 15% for developed market (DM) currencies or 30% for emerging market (EM) currencies.
SUMMARY OF CURRENT THINKING (AUGUST 2024)
| Examples of convictions, DMS (Longs) | JPY: Despite the current BoJ hiking cycle, the JPY continues to remain undervalued. Factors such as the current account surplus, income balance, and rising net external position, and a more active Bank of Japan should remain supportive. | 5% |
| NOK: We are long on the NOK based on the currency’s current undervaluation. In addition, the possibility that Norges Bank may remain hawkish and delay starting its cutting cycle reinforces our view. Meanwhile, other G10 central banks, especially the FED or the ECB are becoming more confident or have already started their own plans to cut interest rates. Hence the rate differential is supportive of the NOK as well. | 5% | |
| Examples of convictions, EM Longs | BRL: We remain positive of the Brazilian Real which is supported by a positive Trade Balance and excessively positive real rates. | 5% |
| INR: This positive view on the Indian Rupiah reflects India’s rapidly growing economy. India’s Trade Balance as also drastically improved especially thanks to exporting services. The currency has become significantly less volatile due to the central bank's inflation-related mandate, which has also helped reduce the budget deficit. Lastly, the inclusion of India's bond in a significant global index lately will continue have a positive impact on the currency. | 3% | |
| Shorts | CNH: China's deflationary pressures are expected to create opportunities for further rate cuts and currency depreciation, hence our short in the currency. In addition, this position is a hedge for a potential win of Trum presidency in US elections. | -5% |
Portfolio composition may be changed anytime without notice. * Net currency includes all currencies except Eur. ** Credit exposure includes spread risk, ie. corporate credit and EM sovereign credit (external debt).
