Currency investment strategy for today’s dynamic markets

The U.S. dollar recently has been quite the performer relative to other major currencies, rising 20% in trade-weighted terms from June 2014 to March 31, 2015. It’s close to parity against the euro and near an eight-year high against the yen.1

Is it time to bet against the U.S. dollar? Certainly the euro has shown some recent signs of life against the dollar, giving dollar contrarians something to ponder. However, our global team of investment strategists still sees upside to the dollar, given continued strength of the U.S. economy as well as diverging policies of the U.S. Federal Reserve and other central banks around the globe, as noted in our 2015 Global Outlook – Q2 Update.

In today’s dynamic markets, it can be tricky to build a currency investment strategy. So, how might we capitalize on what the dollar is apt to do for the rest of 2015? We see three key opportunities:

  1. Develop a strategic plan. One approach we may take is to hedge 50% of a currency risk. This reduces overall portfolio volatility and allows one the ability to make tactical decisions to underweight or overweight any one currency—if you’re 100% hedged or unhedged, there’s only one direction to go. A 50% hedging strategy may also help to reduce common behavioral biases, such as regret. If one were 100% hedged or un-hedged, and a shift in the dollar catches that investor by surprise, behaviorally, the person’s regret might compel him or her to act in the opposite direction at the wrong time.  A 50% hedge might help to counter that potential regret and allow investors to stick with their plan.
  2. Capture long-term excess return in currency through strategic beliefs. At Russell Investments, we believe certain factors have a long-term excess return attached to them. In equity, for instance, we think smaller cap stocks outperform larger cap stocks over a full market cycle.  Within currency, we have similar strategic beliefs – specifically that currencies with better trend, value and carry will outperform currencies with less of these exposures.
  • “Trend” refers to the fact that investors underestimate the power of momentum, selling their winners too soon. Despite some recent choppiness, the dollar still has momentum.
  • “Value”, akin to other asset classes, states that ‘cheap’ currencies will outperform overvalued currencies over the long run. Consider the differing prices of a MacDonald’s Big Mac™, for example, across borders (as seen in the Economist’s Big Mac Index) even though similar goods should cost similar amounts everywhere in the world (with caveats). It differs because various currencies are under- or over-valued. We analyze those currencies, and go long on under-valued currencies and short over-valued currencies.
  • “Carry” holds that over time, currencies with higher interest rates will out-perform those with lower rates. With rates seemingly about to rise in the U.S., and likely to dip in the eurozone and Japan, the dollar currently has the wind at its back.
  1. Capture excess returns and manage currency risk dynamically. Currencies are not always priced correctly and we believe that one may be able to improve outcomes through tactically managing currency risk. At Russell Investments, we use our value, cycle and sentiment framework to look at specific currency pairs rather than ‘the dollar’.  For instance, relative to the USD, the Australian and Canadian dollar currently are both over-valued, have negative sentiment, and a falling interest rate cycle. And with mining stocks taking a hit in Australia and energy prices taking the steam out of Canada, we see more potential for a possible drop in value in those currencies than in the euro or yen. The long term trend of the U.S. dollar is currently upwards, but we believe that being selective in leveraging currency-related investment opportunities, while recongnizing that any investment has risk,  might potentially help results.

That’s a quick tour of currency strategy. It’s a complex world, but with a careful approach, investors may likely take advantage of today’s dynamic currency markets. For more on our market outlook views, please see our 2015 Global Outlook – Q2 Update.

1 Bloomberg, 31 March 2015