Currency
The currency markets of 2009 were less volatile than those of 2008, but equally as interesting. The year began with a strong U.S. dollar as financial turmoil encouraged a flight to higher quality assets. This phase ended in March, and as the equity markets rebounded the U.S. dollar began its slide. The fall of the dollar was exacerbated by fears of inflation brought about by massive government borrowing. For the year, the Euro and Yen rose by over 5%, while commodity currencies such as the Australian dollar were much stronger, rising over 25%, and emerging market currencies such as the Brazilian real were the top performers, appreciating over 30%. Measured from the market lows of March, the gains were even more pronounced with the Euro up over 15%, the Australian dollar up over 40% and the Brazilian real up over 35%.
One of the most interesting aspects of currencies in 2009 was the atypically high correlation to equity markets. In the past, currencies have displayed modest correlation with the markets – averaging less than 20% between 2004 and 2006. However, the dominant financial market theme throughout the year has been the cycle of risk aversion followed by risk seeking. This cycle has played out simultaneously through many financial markets including equities, currencies and commodities, specifically metals. As a result, since the market bottom in March, the daily correlation between the equity market and the U.S. Dollar Index has been over 95%.
Looking forward to 2010, there are several major themes to consider. First, the high correlation referenced above has a negative impact on U.S. based international equity investments. When equity prices fall, so does the currency component that is imbedded in these international equity portfolios. In past environments, the currency might have been viewed as a risk diversifier, but today it clearly increases the risk in international portfolios. Although the high correlation is not expected to last forever, it is expected to persist for some time. In light of this, forward thinking investors will be examining currency risk as a critical aspect of their portfolio management decision.
The second theme involves the continued devaluation of the U.S. dollar. While most market participants expect a lower dollar going forward, there are considerable risks of sharp reversals. The world economy and financial markets have not seen the end of crisis. As shocks sporadically develop, there will be a flight to the relative safety of the dollar. So, while the overall trend may be lower, large counter-trend movements are very likely. This environment provides an expanded opportunity set for investors that look to currency as an efficient and highly liquid source of alpha, in both developed and emerging markets.
Finally, there are two markers to look for in 2010 as they relate to currency. The first is how China will respond to increasing demands for a floating currency. Accommodation and dialogue will result in relative stability while a more combative posture will lead to widely fluctuating currency markets. The second marker is the likelihood of a change in interest rate policy in the U.S. If the Federal Reserve begins raising interest rates because growth has returned, the dollar will rally. However, the dollar will fall if rates rise because the U.S. needs to pay a higher return on its debt in order to attract investors. The outcome of this tension should provide for another interesting year, filled with opportunity in the currency markets.
