Currency investing: is there any value in value?
Can investors exploit "value" and "interest" signals to guide their foreign currency allocation? The answer to both looks like a decisive yes. These concepts can be used to help guide currency investments. In the wake of the post-Brexit vote sterling slump, they caution us to be nervous about the strong dollar hype.
In previous posts (here and here), we’ve highlighted that extreme post-Brexit weakness makes sterling look pretty cheap on several measures. However, a reasonable question to ask is whether those valuation signals tell us anything useful about future prospects. If "cheap" currencies are destined to become "even cheaper" over time, then the valuation signals are fairly pointless. Under that world view, there would be absolutely no value in value.
Likewise, anyone considering hedging foreign currency risk knows that interest rate costs need to be considered. Hedging costs more where interest rates are high (e.g. Brazil) than where they are low (e.g. Japan). However, theoretically these costs are irrelevant. The Uncovered Interest Parity (UIP) condition holds that high interest rates are merely compensation for expected depreciation over time: the interest rate costs of hedging should come out in the wash. So, taking that into account, should we have any interest in interest?
One way to think about these issues is to let the data speak. Over a long enough time period, and a broad enough panel of countries, we should be able to see whether “value” and “interest” are useful lodestars for guiding currency allocation.
The two charts below do exactly that and we see some pretty interesting results. Overvalued currencies (highlighted on the left-hand side) and currencies with exceptionally low interest rates (highlighted on the right-hand side) have typically delivered negative returns for foreign investors. The opposite is true for undervalued currencies and those with exceptionally high interest rates.
We can build systematic strategies that exploit these biases in the foreign exchange market.
So much for the history lesson; what do these “value” and “interest” signals tell us today? After an epic devaluation over the last twelve months, sterling is cheap against lots of other currencies. The flipside to that statement, of course, is that lots of currencies are expensive relative to sterling.
On the interest side of the ledger, the Bank of England has pushed rates down to 0.25% to head off a potential post-Brexit economic slowdown. That is low relative to interest rates available in Australasia, but still offers a decent pick-up over the negative interest rates available in other parts of Europe.
The chart below brings these two concepts together for a sterling-denominated portfolio. Currencies above the diagonal line (e.g. the US dollar, highlighted in yellow) should make investors nervous. They are overvalued and/or have very low interest rates. These are good places to think about decreasing exposure (or “hedging”). Currencies below the diagonal line (e.g. the Australian dollar, also highlighted) offer opportunities. They are undervalued and/or have high interest rates. These could be good places to think about increasing exposure.
So … is there any value in value? Or interest in interest? In the world of foreign exchange, the answer to both questions looks like a decisive yes. Both concepts can be used to help guide currency investments and can be exploited as the basis for a systematic approach to taking dynamic FX exposure.
Today, that framework warns us to be nervous about the strong dollar hype (at least when considered versus the beaten-up pound). That’s hopefully a valuable AND interesting conclusion...