There hasn’t been much volatility in currencies lately. What’s going on?
With the large central banks pivoting to a more accommodative monetary-policy stance, high-yielding currencies should start outperforming low-yielding currencies. This bodes well for emerging market currencies as a whole. High-yielding developed currencies don’t really exist anymore, but the ones that still provide some yield will probably see their central banks succumb to gravity and in turn shift to a more dovish stance as well, in order to avoid too much currency appreciation.
But over the past few years, we haven’t witnessed much volatility in developed currencies, with the chart below showing option-implied volatility and realised volatility for a basket of developed currencies. Why has this been so low?
Many developed central banks have limited policy tools left amid the zero bound on rates and balance-sheet constraints. Currency appreciation tightens domestic financial conditions, so central banks will try to oppose it through tools from verbal intervention to market intervention, and will possibly use it as a reason to cut the policy rate. This dampening effect will suppress currency volatility.
Yet this mechanism also meant currency strength never tended to persist for too long, and betting against central banks has been a painful experience. So while currency momentum had been a popular and successful style for decades, returns from it have started to stutter more recently. The chart below shows three well known currency styles for the past couple of years, including currency momentum:
As can be seen, currency momentum hasn’t performed for some time now. Valuation as a style has been more successful, while carry as a style has been more mixed.
Our experience is similar when we look at the in-house rule-based currency strategies we have developed. One such strategy combines carry and value signals, and has seen good performance over the past couple of years; another strategy, one we switched off back in 2015, continues to do poorly.
But with developed central banks having now pivoted to easier monetary policy again, and the risk of running out of ammo still pertinent, should we contemplate a contrarian momentum strategy? To be continued...
Commenting live on Ray Dalio's views is never going to be easy. While we wouldn't add to gold at these levels, over the medium term we see inflation as a key global risk that is under-priced and could undermine major currencies' real values. We explain why in the following Bloomberg interview.