Notable in recent months have been pronounced swings in currency markets. Unhedged, these can materially influence investment returns, for better or worse. For instance, in September, US dollar returns for sterling and euro-based investors were greatly enhanced by US dollar strength. Conversely, returns for US-based investors in Europe were negatively impacted by the relative strength of the US dollar versus the euro.
However, as well as presenting risk, currency movements can be played to advantage, to both enhance portfolio returns and reduce volatility. Through pair trades, we identify opportunities to exploit the relative merits of two selected currencies on our long-term investment view, looking to profit from persistent structural and economic disparities across the globe.
While the extreme volatility seen in forex markets in September was unusual, it serves to highlight this investment opportunity. For example, our long US dollar positions versus the euro and Japanese yen delivered handsome returns over the month, following the rapid appreciation of the US dollar in relation to other major currencies.
These movements stemmed primarily from the contrasting economies of the US, Europe and Japan, and the divergent monetary responses of their respective central banks. At one end of the scale, the US economic recovery continues to gather pace, stirring speculation over the likely timing of the first interest rate rise since June 2006. Meanwhile, the still languishing economies of Europe and Japan clearly require many more years of easy monetary policy to revive growth and fend off deflation. These economic and monetary dissociations are manifesting in exchange rate movements.
We can also use currency pairs to take advantage of developing market trends. For instance, the Canadian dollar is closely correlated with global oil and mineral prices. By taking a long US dollar/short Canadian dollar position, we can benefit from the continued fall in commodity prices and associated weakness in the Canadian economy. As well as improving portfolio returns, this particular strategy provides an effective shield against flagging global growth expectations, helping to dampen portfolio volatility.
We find similarly compelling opportunities outside the major currencies. Our long rupee/short euro position is predicated on India's improving economic and political prospects, following recent elections. We expect the new government's aggressive structural reforms and counter-inflation measures will, if successful, restore India's economic and political credibility, while also making India more resilient to US rate rises. This should translate into rupee appreciation. By contrast, Europe's need for ongoing monetary support implies further euro weakness for some years to come.
Elsewhere, we made a profit on our currency pair preferring the US dollar versus the New Zealand dollar. Our analysis showed the NZ dollar to be overvalued on a number of metrics and we believed that widely-anticipated rate rises were unlikely to materialise. Our stance was subsequently rewarded when the Reserve Bank of New Zealand expressed its view that the exchange rate was "unjustified and unsustainable", driving the NZ dollar sharply lower.
A currency allocation can therefore offer an effective means of enhancing investment returns and reducing portfolio volatility. In particular, for investors looking to spread risk in the portfolio, currency offers genuine diversification benefits, on account of its low correlation with other asset classes.