Active currency: a vital diversifier in a low yield world Part 1

There weren’t many winners from the washout of the 2008 financial crisis, but as the efficient market theory floundered, Keynesian economic policy re-emerged to steady the ship. Easy money sloshed through the US economy and before long other countries were following suit.

One outcome is that fixed income volatility has been smothered even as fixed income prices have surged, thanks to a mix of zero-bound interest rates in major economies and massive central bank bond buying programs. While all this has narrowed the fixed income opportunity considerably, volatility remains in currencies, an asset class which has proven more price sensitive to shifts in economic policy.

Quantitative easing swelled the US Federal Reserve’s balance sheet as it went all out to kick-start the economy. While QE in the US has been halted, it continues apace in Europe and Japan. Even China is doing its own form of QE via the loan to bond programme for State Owned Enterprise debt – mostly being bought by China’s three policy banks.

Economic purists may decry these kinds of unconventional measures, but central banks aren’t going to be indifferent bystanders when economies are floundering. So thumbs up to central banks for stepping up and doing whatever it takes to revive inflation from unusually low levels and to encourage investment and consumption.

But there’s also been a downside: bond prices have pushed up steeply and yields have shrunk.

In Europe, the net annual supply of bonds has fallen into negative territory on the back of ECB buying and fixed interest investors need to go out 7 years on the maturity spectrum before running into positive yields. On the JPM Global Government Bond Index, there is $2.9 trillion (or 13.5 per cent) worth of assets now trading with a negative yield.

The end result is that bond prices have hit great heights and they’re no longer moving as strongly with monetary policy announcements as might be the case in ‘normal’ circumstances.

How could they when the largest actors by-far are major central banks buying securities?  

But volatility has not vanished. Investors just need to move down the road into currency markets where there isn’t this huge one way bid.


Currency wars

Whether central banks are explicit about it or not, a key intended consequence of unconventional monetary policy is currency depreciation and the battle for inflation. The fight for moderately positive inflation shows just how much the world has changed.

Central banks fought for several decades to bring inflation under control. Now the fight is to lift inflation from unusual lows. But that’s an aside.

Easy money is always going to lead to some level of depreciation of a country’s exchange rate. In  fact, this is an important outcome. Increased buying in a certain denomination should boost inflation as imports become more expensive and exports become more competitive.

This is a potent channel through which QE impacts the real economy and for fixed interest investors it represents a welcome source of volatility when bond yields have flattened.

There was a good example of this in early 2015 when a significant number of countries cut rates in surprise moves in quick succession in order to arrest the appreciation of their currencies.  Australia joined the bandwagon too – the rate cut in February certainly had the hallmark of ‘if you aren’t cutting you’re hiking’ about it.

Finding the right balance is the key and many central bankers have waited in anticipation for the US Federal Reserve to finally initiate the lift-off in rates. Through 2015 the FOMC remained painfully cautious. They were all too aware that monetary tightening at home would see the Greenback appreciate, while at the same time taking the pressure off other major currencies such as the Euro.

Mid-way through 2015 saw the push out of the Fed’s first hike, causing the EUR to rally (USD to fall) and exacerbating the need for more QE in Europe.

This flowed into December but this time around the ECB’s stimulus announcement surprised the market by locking in less easing than had been anticipated. The deposit facility rates were cut from -0.2 per cent to -0.3 per cent, but the size and increment of the asset purchase program was lean.

The Euro appreciated immediately, which was not ideal, but the alternative (ramping up QE) would have certainly inflamed the currency wars as other economies worked to drive their own depreciation.

In mid-December the FOMC made their most anticipated announcement of the decade with a rate hike that saw an immediate slip in the Euro against the USD. As funds headed back to a resurgent USD there were tentative signs of relief from ailing economies which had been struggling to keep their heads above water, yet still, they were far from reaching dry land.

Japan has been mired in slow growth for many years but its easing program has remained relatively steady for a year now. As Europe continues to ease further, the BOJ will be feeling the pressure to do more on the depreciation front.   In December the BOJ increased the duration of its purchase programme – reaching further out the yield curve for its monthly JGB fix.

With monetary policy rates at or near zero for many of these countries – currency is the battleground and it’s where the volatility is – there is an asymmetry to how rates can move given the close proximity to the lower bound.



Important Information

QIC Limited ACN 130 539 123 (“QIC”) is a wholesale funds manager and its products and services are not directly available to, and this document may not be provided to any, retail clients.  QIC is a company government owned corporation constituted under the Queensland Investment Corporation Act 1991 (Qld). QIC is regulated by State Government legislation pertaining to government owned corporations in addition to the Corporations Act 2001 (Cth) (“Corporations Act”). QIC does not hold an Australian financial services (“AFS”) licence and certain provisions (including the financial product disclosure provisions) of the Corporations Act do not apply to QIC. Some wholly owned subsidiaries of QIC, including QIC Private Capital Pty Ltd, QIC Investments No 1 Pty Ltd and QIC Infrastructure Management No 2 Pty Ltd, have been issued with an AFS licence and are required to comply with the Corporations Act.  QIC also has wholly owned subsidiaries authorised, registered or licensed by the United Kingdom Financial Conduct Authority (“FCA”), the United States Securities and Exchange Commission (“SEC”) and the Korean Financial Services Commission.  For more information about QIC, our approach, clients and regulatory framework, please refer to our website or contact us directly.

To the extent permitted by law, QIC, its subsidiaries, associated entities, their directors, employees and representatives (the “QIC Parties”) disclaim all responsibility and liability for any loss or damage of any nature whatsoever which may be suffered by any person directly or indirectly through relying on the information contained in this document (the “Information”), whether that loss or damage is caused by any fault or negligence of the QIC Parties or otherwise.  This Information does not constitute financial product advice and you should seek advice before relying on it.  In preparing this Information, no QIC Party has taken into account any investor’s objectives, financial situations or needs. Investors should be aware that an investment in any financial product involves a degree of risk and no QIC Party, nor the State of Queensland guarantees the performance of any QIC fund or managed account, the repayment of capital or any particular amount of return. No investment with QIC is a deposit or other liability of any QIC Party. This Information may be based on information and research published by others.  No QIC Party has confirmed, and QIC does not warrant, the accuracy or completeness of such statements.  Where the Information relates to a fund or services that have not yet been launched, all Information is preliminary information only and is subject to completion and/or amendment in any manner, which may be material, without notice. It should not be relied upon by potential investors.  The Information may include statements and estimates in relation to future matters, many of which will be based on subjective judgements or proprietary internal modelling. No representation is made that such statements or estimates will prove correct. The reader should be aware that such Information is predictive in character and may be affected by inaccurate assumptions and/or by known or unknown risks and uncertainties. Forecast results may differ materially from results ultimately achieved.  Past performance is not a reliable indicator of future performance.

This Information is being given solely for general information purposes. It does not constitute, and should not be construed as, an offer to sell, or solicitation of an offer to buy, securities or any other investment, investment management or advisory services in any jurisdiction where such offer or solicitation would be illegal. This Information does not constitute an information memorandum, prospectus, offer document or similar document in respect of securities or any other investment proposal. This Information is private and confidential and it has not been deposited with, or reviewed or authorised by any regulatory authority in, and no action has been or will be taken that would allow an offering of securities in, any jurisdiction. Neither this Information nor any presentation in connection with it will form the basis of any contract or any obligation of any kind whatsoever. No such contract or obligation will be formed until all relevant parties execute a written contract.  QIC is not making any representation with respect to the eligibility of any recipients of this Information to acquire securities or any other investment under the laws of any jurisdiction. Neither this Information nor any advertisement or other offering material may be distributed or published in any jurisdiction, except under circumstances that will result in compliance with any applicable laws and regulations.

Copyright QIC Limited, Australia.  All rights are reserved.  Do not copy, disseminate or use, except in accordance with the prior written consent of QIC.


About QIC

Investment Capabilities

Knowledge Centre

Latest News

About QIC