Financial markets The state of play for currencies

The state of play for currencies

Investing in foreign currencies does not usually generate excess returns compared with holding domestic cash. When currencies are clearly undervalued, however, it can be worth taking such positions. Conversely, holding low yielding safe-haven currencies pays off when risks spike significantly.

Currency markets provided a number of surprises in 2018. Forecasts generally assumed that the major currencies would be able to build on their gains in 2017 against the USD. Yet the stronger-than-expected growth momentum in the USA prevented them from doing so. In response to strong growth, the US Federal Reserve (Fed) continued to raise rates while the central banks of other advanced economies retained a dovish stance. The interest rate or carry advantage (positive difference in interest rates between two currencies) for the USD thus increased. Furthermore, the worsening US twin deficit did not weaken the USD.

Looking ahead to 2019, we believe that a further surge of the USD is unlikely. While US growth is likely to remain higher than in other advanced economies, the gap should narrow. As for US central bank rates, they will remain significantly higher than in other advanced economies, with the gap likely to even widen until mid-2019. If growth and inflation continue to pick up outside the US, non-US central banks may, however, start tightening sooner. Finally, our valuation screen shows a moderate USD overvaluation against the other major currencies. It is hard to tell whether the twin deficit might re-emerge as a risk factor for the USD. This would most likely happen if US economic growth slowed markedly, a development we consider unlikely in 2019.

As for emerging market (EM) currencies, we sense a bigger shift in fundamentals: policymakers in many EM were forced to raise interest rates as their currencies came under pressure in 2018. As a result, the carry between EM currencies and the USD has increased, in some cases substantially. At the same time, the valuations of a number of currencies have become more attractive. This suggests that both carry and valuation-based strategies may once more be effective assuming fundamentals stay constructive. Specifically, currencies will only appreciate if the external balance of the respective country stabilizes. Progress on rebalancing should therefore be watched carefully.

Political twists in the road

In 2018, political events also impacted certain currencies. The escalating trade tensions between the USA and China depressed the RMB, while the close economic links Japan and China may have prevented the attractively valued JPY from appreciating. In Europe, worries over Italian fiscal policy temporarily boosted the CHF, while the GBP swung back and forth with every twist in the road leading to Brexit. Looking to 2019, we do not think that the US-China trade conflict will be resolved quickly. As a result, the RMB may remain under pressure. Insofar as the Chinese authorities continue to ease monetary policy, this trend is set to persist. Yet we believe that China will proceed cautiously to avoid triggering investor uncertainty and capital outflows. As regards the conflict over the budget deficit between Italy and the European Union, we believe it is quite unlikely that the European Central Bank will give in to Italian political pressure. Hence the EUR currency pairs should be little affected by these tensions. Meanwhile, valuation remains highly supportive of the GBP, implying that a soft Brexit may well help close the valuation discount. Conversely, a hard Brexit and its ensuing chaos would intensify pressure on the GBP.

EM currencies look more attractive

The developments of the past year appear to have produced a situation in which value and carry overlap for a number of currencies. Investors may thus be able to generate excess returns after a disappointing 2018. Among the advanced economy currencies, the GBP, NOK and SEK looked clearly attractive based on our valuation screen as we went to press. Among EM currencies, the TRY and MXN seemed attractive. The NZD and CHF appeared expensive, while the only EM currency that looked expensive was the THB.

In terms of carry, two EM currencies, the BRL and TRY, looked attractive. Overall, our expectation of a fairly benign inflation picture in EM and a very wide real rate differential relative to developed markets, including the USD, suggests that other EM currencies may also outperform the USD. Meanwhile, some of the traditional advanced economy carry currencies, in particular the AUD, have lost appeal in the wake of Fed tightening. Among the safe haven currencies, the valuation divergence between the somewhat overvalued CHF and the undervalued JPY should close, especially if trade war concerns abate. In conclusion, investors who hold large amounts of cash in low-yielding currencies (i.e. the CHF and EUR) that trade within their fair value band should be able to enhance returns by taking positions in some of the value or carry currencies described above. For USD-based investors, there is less incentive to take such positions as US cash returns are higher. That said, with the USD somewhat overvalued and the twin deficit making a possible comeback as a risk factor, limited diversification might improve portfolio performance as well.