By Roger Hallam
Global currency volatility is meaningfully up from last year. In some instances, investors have sustained significant losses on foreign currency exposures, escalating currency risk to a top of mind concern for investors. Navigating global FX will continue to be incredibly important for investors who need to be mindful of strategic hedging considerations as well as opportunities for currency overlay managers to generate alpha in a more volatile environment.
There are a few key themes and dynamics that will dominate the global currencies space over the next several months.
The prevailing trend for the last year has been all about a strong US dollar and we’d expect that trade to continue, albeit for different reasons. In 2014, investors didn’t have to think the US Federal Reserve was going to tighten monetary policy to be bullish on the US dollar, given the relative actions by the Bank of Japan and the market expectations towards the European Central Bank. We do think the US Federal Reserve will need to move on raising interest rates by mid-2015 for the strong dollar trade to continue. As US unemployment levels approach the upper end of US Federal Reserve’s target estimate of NAIRU, we think zero interest rates look less and less appropriate. Therefore the continued stronger dollar theme may be propelled forward by the normalisation of the monetary policy in the US, in relative comparison to ECB quantitative easing weakening the euro.
Turning to the euro, it is starting to look cheap at current levels from a purchasing power parity valuation standpoint. Nevertheless, powerful flows working against the euro will continue to weaken it in the near term, in our view. For example, US institutional investors hedging up their non USD exposure are contributing to the size and pace of flows pushing down the euro. Meanwhile eurozone domestic investors are looking abroad for higher returns and higher yields. So with various negative factors at play, we see scope for further declines even from the current low valuation levels.
In terms of the GBP outlook, there is more complexity. The fundamentals look shaky given the United Kingdom’s large current account deficit and the large fiscal deficit during a time of political uncertainty with the upcoming general election. In the election year of 2010 we saw an 8% peak to trough decline in the currency around the time of the general election, but this time the market is well aware of these issues. It is also not clear which alternative political outcome is better for sterling, given uncertainty around the possibility of an EU referendum in the event of a Conservative government and Labour’s poor fiscal record the last time they were in office. Post the general election, with the Bank of England likely to follow the US Federal Reserve in raising rates around the end of the year, with believe Sterling could continue to outperform the Euro.
Further afield, the outlook for the Japanese yen is also clouded. On the positive side of the ledger, the currency is very cheap by most traditional valuation metrics, it has improving fundamentals in terms of Japan’s trade balance (their current account deficit is now actually a surplus) and some of the drivers of yen weakness, such as pension fund flows into foreign securities may have already peaked. However, on the flip side, the Bank of Japan continues to ease aggressively and may ease further this year. To the extent that they are fully monetising their debt, the yen could take that negatively. We don’t currently hold a strong view one way or another on the yen.
Roger Hallam is chief investment officer for Global Currencies at JP Morgan Asset Management
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