Buford Scott, managing partner at Stelrox Capital Management, discusses opportunities in currency investment in a world of diverging growth and monetary policy.

There are more ways than investors might assume to execute market strategies via the route of foreign exchange. The average daily turnover of currency markets is an astonishing $4 trillion per day, making it the world’s most liquid. What opportunities for wealth managers exist here? In this article, Buford Scott, managing partner of Stelrox Capital Management, and chief investment officer of the C-View Stelrox Systematic Currency Strategy, sets out some ideas. Scott is also former managing director and global head of the alternative asset group at Standard Chartered.

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It’s been nine years since we’ve had a rate hike in the US or UK. Last week, both countries warned, in no uncertain terms, that rate hikes are imminent. Markets expect that the hiking cycles will continue for years, as accommodative monetary policy is withdrawn by the Federal Reserve and Bank of England. Central bankers in other parts of the world continue policies of monetary stimulus, as their economies remain lethargic. The European Central Bank, for example, last week reiterated its commitment to its proscribed course of quantitative easing, especially given the uncertainty still surrounding Greece. The Bank of Japan similarly reaffirmed its stance to maintain stimulus, as Sweden, Switzerland, Canada and China have done. With US rates set to rise, and a disjointed growth picture amongst major economies, the investment future for many assets has become hazy. Equity and bond markets have become increasingly difficult to predict. However, the future for currency investment has seldom been brighter, as these same conditions create a boon for currency traders.

Traditional investors in bonds and equities face uncertain times. Many are seeking investments that thrive in a world of divergent growth and rising interest rates. Ideally, such investments would be highly liquid, transparent, with minimal transaction costs. A solution is hiding in plain sight: the global currency markets. Currency investments thrive in a world where growth and monetary policies are in clear divergence. Trends can last for years, and opportunities to exploit interest rate differentials abound.

Transparency, liquidity, and market access far exceed the standards of other markets. Volume in the global currency markets dwarf all other financial markets, combined.  

Many argue that currencies don’t constitute an “asset”, hence are not worthy of specific investment. Currencies are issued by sovereign creditors, and have a calculable and transparent yield, in common with most other financial assets. Whether asset or not, clear profits can be achieved in foreign exchange trading. Currencies form a core focus for macro hedge funds, and there is a thriving community of managers that focus exclusively on the sector. These managers are able to achieve levels of diversification that are not possible in other markets, by pairing currencies in hundreds of different, uncorrelated ways, to exploit relative value differences between two countries in a multitude of geographies.

With the developing backdrop of macroeconomic policy divergence - the fertiliser for alpha growth in currency investment - the focus on currency trading is intensifying. After seven years of uniform, low-rate monetary policies globally, currency volatility, and sustained trends, have reasserted themselves over the past twelve months - and there hasn’t been a single rate hike over that period. Over the coming months and years, currency managers are excited by the prospects offered by divergent growth rates and monetary policy - the very same prospects that are causing sleepless nights for bond and equity managers.

How to do it
So, what is the best way to capitalise on the growing opportunity in currencies? There are many approaches, but three dominate: trend-following, carry, and value trading. Conditions for all three look encouraging. Trend-followers are encouraged by market expectations for definitive rate hiking cycles in some countries (e.g. US, UK) whilst others are still implementing quantitative easing policies (for example, Japan and the eurozone). This clear divergence creates persistent trends in currencies - in the last year some of these currency pairs have moved as much as 25 per cent, driven by rate expectations.

Currencies with rising interest rates tend to appreciate faster than their lower yielding counterparts, a fact not missed by carry traders either, who focus on rate differentials. Current rate differentials in the developed world are trending higher, from the all-time lows experienced in 2014. Currency carry trades benefit not only from rate differentials between currencies, but also the cross-rate appreciation of the position. The latter effect tends to be most extreme at the early stages of a rate hiking cycle.

Finally, value traders are heartened by the distortions in currency values caused by central bank intervention and stimulus over the past seven years. As these measures are unwound, we may see unprecedented value adjustments, as fundamental economics reassert themselves as a driver of currency value - the Swiss franc [exchange rate surge] in January is an extreme case in point. While value trading is a longer term effect requiring patience and diversification (as in all markets), it can be one of the most rewarding in the long term.

Recent geopolitical events have reminded investors that currency markets are a force to be reckoned with, after a recession-induced lull in volatility. The messages from central bankers are clear: rate rises are coming; prepare for them. Investors may find challenges to surmount in their equity and bond portfolios, but those diversified into currency investments are likely to reap benefits over the coming years.

Additional point
Currencies can serve as a proxy trade for other markets, and in many cases are the most efficient way to express a market view. In equities, for example, the Bank for International Settlements highlights in its recent annual report that a 1 per cent depreciation in the euro has, on average, coincided with a rise in equity prices of around 0.8 per cent. An equity bull encouraged by the effects of monetary stimulus on eurozone equities could achieve the same result with a euro/dollar position, at a fraction of the transaction costs, with far superior liquidity than a basket of eurozone equities. A leveraged investor would find his margin costs on the currency position a sliver of that required for the equity position, finding his return on margin deployed a multiple of the equity investment.

Similarly, currencies can serve as a low cost, and efficient proxy for a short-term bond, with none of the local market access or clearing requirements (or costs). Currency forwards have local interest rates incorporated, so an investor who buys the local currency and invests it in, say, a three-year bond, can achieve much the same result by buying the local currency three years forward. The implied interest rate and local currency risk will match, with no requirement for a local bond market maker or local clearer. Again, a leveraged investor will find return on margin deployed of his currency investment a multiple of the bond investment.